Reserve Bank expected to keep cash rate on hold

At its monthly board meeting tomorrow, July 3, the Reserve of Australia will almost certainly keep its cash rate at the historic low level of 1.5 per cent.

The last time the RBA board moved rates was when it cut in August 2016. Prior to this decade we would have seen the cash rate closer to 6 per cent or more given the rates of inflation and unemployment that we currently see in the economy.

The cash rate is the main RBA instrument, and has a powerful impact on all other interest rates in the Australian economy, such as mortgage and business borrowing rates. Other factors, and particularly international factors, also affect these interest rates, but the RBA does have a lot of power over the economy and interest rates through its ability to control the cash rate.

It might seem unambiguously a good thing to have interest rates so low, but the fact is that this isn't the case.

Firstly, there's a distributional impact with borrowers being better off, while lenders are worse off through having lower-interest income – in Australia, many older people are savers and in this latter category.

The second issue with lower interest rates is that they encourage people to borrow. This, of course, is the point and supports the economy, but it also creates risk. In Australia, household borrowing levels are extremely high, largely due to low interest rates and strong demand for housing.

The problem with excessive borrowing is that it can lead to a number of distortions in the economy, which can create huge economic problems when rates rise.

In the United States, rates were left too low for too long after the 2001 recession, leading to a housing price bubble. These low rates were a leading cause of the problems unleashed during the GFC. As rates were very slowly normalised, housing prices fell and banks and others exposed to housing faced massive problems.

So why not leave rates low forever and not risk raising rates?

The RBA does have control over the cash rates, but our banks borrow heavily from offshore, so offshore factors will also affect local rates. It could be that the RBA leaves cash rates low, but liquidity pressures internationally see mortgage and other rates increase anyway.

It's also very difficult to know whether housing price levels and high household debt will lead to significant problems, but the RBA would be wise to try to limit further growth in both.

If the RBA raised rates, this would affect the psychology of household and other borrowers.

"In my view a couple of rate rises in the next six months would be appropriate."

If rates rise once, borrowers would then be concerned about further rises, and moderate their borrowing. This is a very delicate balancing act for the RBA.

It's always in the business of influencing market psychology, which is always difficult to predict. But in my view a couple of rate rises in the next six months would be appropriate. This should be enough to tilt expectations towards more caution, but not enough to cause significant damage to the economy. The risk is that not doing this leads to much greater damage later.

The criticism of this policy of raising rates now is that it's damaging the economy now to give the RBA more room to move later on. This is correct, but again it's also the case of the extent of imbalances that the current very low rates are causing.

Internationally, rates are rising, and this will also put pressure on rates to rise. The RBA has signalled that it won’t be raising rates in the next few months, but I believe this is just putting off a necessary rise for too long.