Freshman Reserve Bank governor, Philip Lowe, kept interest rates unchanged at his first board meeting as governor this month.
Does that mean the Reserve Bank has abandoned its job of supporting the economy?
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In his first address as RBA Governor, Philip Lowe says the economy is adjusting well after the mining boom. Courtesy ABC News 24.
No. It's a natural tendency of mortgage holders - and the media - to focus on interest rate changes, when the bank decides to lower its official cash rate, with immediate flow-on effects to commercial rates – the rates that households and businesses actually pay.
But it's important to take a step back and remember that interest rates are already at half century lows.Even if interest rates stay the same for the foreseeable future, low interest rates are working every day behind the scenes to stimulate the economy.
![Australia's housing market is taking off again as low interest rates stimulate demand.](/web/20170102053132im_/http://www.canberratimes.com.au/content/dam/images/g/r/w/v/t/f/image.related.articleLeadwide.620x349.gs28uy.png/1476507793635.jpg)
How?
There are several ways in which lower interest rates (and conversely, higher interest rates) flow through to the economy.
All are aimed at increasing – or decreasing – the level of spending, or 'domestic demand' in the economy. In reality, the Reserve Bank can't create demand out of thin air. But it can alter the cost of borrowing to either pull forward future demand or push it out.
From there, it's but a few simple steps towards influencing price increases in the economy – the Reserve Bank is an inflation targeting central bank, after all. When domestic demand is weak, prices rise more slowly. When demand is stronger, prices rise more quickly because businesses can increase their prices and workers can demand higher wage rises.
The first of the five main "transmission channels" - or ways in which the Reserve can influence demand in the economy - is known by the fancy name of "inter-temporal substitution". Inter-temporal just means "between time periods". That is, by lowering or raising the cost of borrowing, the Reserve can influence people's decisions about whether to spend today versus save for tomorrow.
The second "transmission channel" of monetary policy is the "cash flow" channel. When interest payments fall, borrowers have more spare cash to splash. It's true they can also choose to keep repaying their debts at higher levels – something that many Australian households have done in the wake of the global financial crisis. But even so, building this type of buffer brings forward the day when households feel comfortable to spend again.Â
![Illustration: Glen LeLievre.](http://web.archive.org./web/20170102053132im_/http://www.smh.com.au/content/dam/images/g/s/2/p/l/5/image.imgtype.articleLeadwide.620x0.png)
Illustration: Glen LeLievre.
It's also true that some households have no debts and instead rely on incoming interest payments from savings to live. These households experience a cash squeeze when interest rates fall. But because the value of Australian household debt exceeds the value of household deposits, the net effect is to boost household spending.
A third channel through which lower interest rates are working to boost domestic demand is by bringing about a lower exchange rate than otherwise. It's true that the Aussie dollar has not fallen by as much as would be expected given lower rates. But it has fallen, and a lower currency boosts domestic demand by helping exporters to export more, and by making imports more expensive, prompting consumers to purchase domestic products instead.
A fourth channel, is the impact that lower interest rates have on inflation expectations. Low interest rates might lead some to worry about the strength of the economy. But they should also give households the confidence that the independent central bank will do everything it can to ensure that prices will continue to rise by between 2 to 3 per cent a year over the long run. Workers know they should keep demanding pay rises of that amount, and businesses know they should keep awarding them.
Finally, there is the wealth effect of interest rate changes. Interest rate cuts tend to inflate asset prices. By reducing the cost of borrowing, interest rate cuts increase demand for assets such as housing and equities. When supply of those assets is relatively fixed – as it is with housing supply – prices tend to rise.
Is that such a bad thing? It is if you're trying to buy a home. But for the two thirds of households who already own their home – outright or via a loan – rising home values boost wealth and households' confidence to spend.
The relative importance of these channels – inter-temporal substitution, the cash effect, the exchange effect, the expectations effect and the wealth effect – can vary over time.
A stubbornly high exchange rate has dampened the third channel and high levels of existing household debt have dampened the others.
As former governor, Glenn Stevens, said in his farewell speech, this dampening of some of the channels of monetary policy puts fiscal policy – the budget decisions of government – back in the driver's seat should further significant boosts to domestic demand be needed, say in the event of another global shock.
But even without further action, lower interest rates are already working every day to encourage demand and, ultimately, inflation.
It might not happen overnight, but it will happen.
Ross Gittins is on leave.
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