Interest rate hits record low

25 Aug 2016

By Shadforth Financial Group

Reserve Bank of Australia adopts a monetary easing bias

The Reserve Bank of Australia (RBA) lowered the cash rate unexpectedly by 25 basis points during the quarter to 1.75 per cent and in early August further cut the rate to an historical low of 1.50 per cent. Inflation was an important catalyst in the decision to lower the main interest rate because it is currently well below the RBA’s medium term target zone of two to three per cent.

Headline inflation for the first quarter recorded a very weak negative 0.2 per cent in the three months through March, leading to the annual rate falling to 1.3 per cent. This caught the share market by surprise and sparked concern about deflation. Deflation is difficult for the RBA to manage because it prompts consumers and businesses to delay consumption and investment as they believe prices will continue to fall.

The RBA was also concerned that the strong Australian dollar, which reached over US 78 cents at one point during the quarter, would hold back Australia’s economic progress. The RBA cut the cash rate again in early August owing to weakness in inflation caused by low wage growth, softer rental and housing construction markets and declines in the cost of business inputs.

2016 Federal Election — political uncertainty continues

Treasurer Scott Morrison delivered the 2016/17 Federal Budget during the marathon eight week election campaign. The Treasurer forecast economic growth of 2.5 per cent up until 2016/17 against a backdrop of challenging global economic conditions that will see the budget lead to a $39.9 billion deficit in 2015-16.

The Government will have a tough balancing act between focusing on responsible spending constraint and also ensuring Australia’s economic success by driving growth through new investment and job creation. The deficit is projected to decrease to $6 billion by 2019/20, but this projection is susceptible to headwinds facing the global economy which could affect efforts to reduce the deficit.

Malcolm Turnbull ultimately claimed victory in the election and won the 76 seats needed to form majority government, however, he will face a potentially hostile Senate with no guarantee of achieving structural reforms. A lack of progress on any serious structural reform to reduce the deficit will leave the task of supporting the economy on the RBA’s shoulders.

Brexit — A ripple effect

Market performance over the June quarter was largely driven by the United Kingdom’s (UK) decision to leave the European Union (EU) in a shock 52 per cent in favour and 48 per cent against outcome that signalled the beginning of a lengthy period of  uncertainty.

The initial market reaction sent markets plummeting by up to 9 per cent but concerns seemed to recede within a week as share market indices recovered to levels seen prior to the vote. The economic impacts are difficult to assess but the risks are  predominantly centred on the Eurozone.

It is unlikely that Brexit will have a significant impact globally because trade with the UK is small for most economies. Less than 5 per cent of Australia’s total exports go to the EU, including the UK, so even a large decrease in exports to the EU will have a minimal impact on Australia’s growth.

The impact is expected to be localised within the Eurozone and this will be reflected in the EU and UK struggling to hit their 2016 and 2017 growth forecasts because business confidence, investment and consumption will be negatively affected over the short term.

We expect this will put pressure on the Bank of England and the European Central Bank to adopt additional monetary policy measures in 2016 to cushion the fallout from Brexit.

US Federal Reserve — a credibility issue?

The US Federal Reserve, commonly referred to as the Fed, maintained the federal funds rate in the target range of 0.25-0.50 per cent in the June quarter as market expectations for monetary policy tightening in 2016 fell from four increases to no increases. The Fed surprised the market a number of times as it yo-yoed between dovish and hawkish stances after it became concerned by new economic data while on the verge of raising rates. Communication from the Fed has been used to prepare the market for a rate increase sooner rather than later because the Fed understands that rates should be higher than current levels at this point in the economic cycle following a recession. In a typical recession, the Fed would respond by cutting rates by four to five per cent, however, it currently does not have the scope to do so in the event of an unexpected economic shock.

It is likely the Fed will use any form of positive data to shape market expectations for a rate increase but it will do so cautiously. The Fed’s changing view on interest rate hikes has created a credibility issue with investors because markets place significant emphasis on the likely direction of interest rates. Communication from the Fed will be cautious in the future but it is still pricing in rate increases for 2016 even though the bond market is not.

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