Two more cuts to the official cash rate are on the cards for 2016.
Despite the Reserve Bank of Australia (RBA) already cutting the cash rate to 1.75 per cent in May, AMP Capital chief economist Shane Oliver has forecast that the cash rate will hit 1.25 per cent “by year end”.
Mr Oliver predicted the central bank may sit tight in June, but said “given the downside risks to inflation, particularly with wages growth falling to a record-low 2.1 per cent, constrained growth and the still-high Australian dollar, more rate cuts are likely”.
There has been growing concern in 2016 that central banks around the world are “out of ammo when it comes to reinvigorating global growth and preventing deflation”, Mr Oliver said, with some fearing that the RBA is “going down the same ‘failed path’ as other major central banks” with its latest rate cut.
May’s cash rate reduction, however, was entirely justified, he said.
“The latest RBA rate cut, which took the official cash rate to a record low of 1.75 per cent, surprised many because recent economic data in Australia has been OK. But the reason for the cut is simple: inflation has fallen well below the RBA’s 2 per cent to 3 per cent target, the weakness in prices was broad-based and inflation is expected by the RBA to remain below target or at the low end of the target for some time.”
Sustained deflation, he said, could “cause big problems”, with wider implications for investors.
“Falling wages and prices would make it harder to service debts. Lower nominal growth will mean less growth in tax revenues, making high public debt levels harder to pay off. And when prices fall, people put off decisions to spend and invest – which would threaten economic growth.
“This could risk a debt deflation spiral of falling asset prices and falling incomes, leading to rising debt burdens, increasing defaults, spurring more falls in asset prices, etc.. There are good reasons why central bank [wants] to avoid that.”
With the current easing bias displayed by the RBA, Mr Oliver said some investors and observers are concerned further cuts would do more harm than good, by cutting into the spending power of retirees and forcing those approaching retirement to save more.
“The proof is in the pudding” though, according to Mr Oliver, who noted that household deposits in Australia are swamped by the level of household debt, with “the household sector a huge net beneficiary of lower interest rates”.
In addition, the fall in interest rates has helped the economy rebalance as mining investment has collapsed, he said, “first via a pick-up in housing construction and more recently via growth in consumer spending of close to 3 per cent per annum”.
“While those close to retirement may be saving more because of lower investment returns, the household saving rate overall has drifted down from 11 per cent to around 8 per cent since the first RBA rate cut in late 2011.
“And of course, RBA rate cuts have helped push the Australian dollar lower. So overall, rate cuts do work.”