As published in The Australian on Saturday 17 September 2016
While our Olympians and Paralympians have been doing us proud in Rio, Australia has also been blitzing the field in the economic stakes. However, this gold medal, for the highest cash rate compared to other AAA rated sovereigns, is both a blessing and a curse
But before I explain why, you need to understand a bit of the context.
Who sets the cash rate and why it matters
Globally, central banks set the cash rate target for their countries and in Australia it is the Reserve Bank of Australia (RBA) that has responsibility for setting the target rate. The RBA is responsible for formulating and implementing monetary policy and uses short term interest rates to achieve its domestic policy objectives.
The cash rate is calculated simply as the weighted average of the overnight interbank cash rates quoted by domestic banks. In other words the rate at which they lend money to each other for unsecured loans.
The RBA announces the target cash rate following its monthly board meeting and then uses open market operations to ensure the demand and supply of money in the payments system is consistent with maintaining that cash rate.
One of the RBA’s main objectives is to maintain inflation within a 2 to 3 percent range and the tool it uses to do this is the target overnight cash rate.
We’re lucky to have a robust enough economy where there is still growth and inflation which means the RBA board hasn’t had to cut the cash rate as much as other central banks. At 1.5 percent it sits well above other AAA rated countries including the Germany, Canada and Switzerland.
Historically our cash rate has been relatively higher but the gap is narrowing.
Changes to the official cash rate generally have flow on effects to longer term rates and the RBA, through its manipulation of the cash rate, sets the benchmark against which alternative uses of funds are compared.
This principal is much the same employed world wide.
Practically all central banks of developed countries are trying to stimulate economies and increase inflation by using ultra low interest rate settings. Some have gone a step further to try and stimulate growth and inflation. In Europe the European Central Bank (ECB) is buying corporate bonds and in Japan the central bank is buying equities. This is known as Quantitative Easing.
There’s so much cash in the system that rates keep getting lower and in some cases turn negative. Yet investors still invest in government bonds and others with negative yields for two main reasons:
- In anticipation that yields could move lower again and the bond prices rise, providing a capital gain
- They are so nervous about global financial markets that they invest because the bonds are issued by highly respected entities and considered ‘safe haven’ assets, that is capital will be preserved no matter what happens
A relatively high cash rate is good and bad
In Australia we still have positive annual inflation, growth and a comparatively high cash rate, so are envied by other economies, still struggling eight years after the GFC and trillions in stimulus.
While our cash rate is at historic lows, it’s not on a relative basis.
Big global investors such as banks and insurance companies, superannuation and fund managers have mandates that require them to invest minimum amounts in AAA rated securities. With our cash rate a relative stand out (and thus other investment rates) it draws foreign investors and their capital inflows to Australian dollar denominated government bonds, thus also supporting our currency.
This is great for those that want to buy imported goods or travel overseas but not so good for exporters, universities that want to attract foreign fee paying students and for tourism.
Yet depositors are the most impacted by a low cash rate. Pity the poor retiree who is trying to survive on their savings with good term deposit rates now those starting with a three and barely increasing to around 3.5 percent over the next five years.
For now we should still be thinking that we live in the ‘lucky’ country. Deposit rates in other countries are much lower and in some there is talk of banks charging to hold deposits.
We wait and watch for the cycle to turn but there seems no magic bullet; growth hasn’t resurfaced and many central banks still long for inflation.
At home, the Consumer Price Index figures that are released in late October will be critical. It’s thought another low inflation figure will prompt the RBA board to once again cut the cash rate target.