Australia’s New ‘Deflationary Interest Rate’ Problem

Like most Australians, you’re probably already well versed in the effects of deflation on the economy. That is, when you expect lower prices in the future, you’re more likely to put off spending today. And that, as the Reserve Bank never fails to remind us, is problematic. Not for you, the consumer who benefits from lower prices in the future, but for the economy as a whole, which reels on the back of lagging activity.

Curiously, this deflationary problem could be starting to affect the market’s perception of interest rates, too. To explore this in more detail, we first need to see how we got here.

First, to good news for investors.

August is already shaping up as a potential bumper month for two of Australia’s favourite asset classes: stocks and property. The latest inflation figures released by the Australian Bureau of Statistics have increased the likelihood of an interest rate cut next month.

Earlier today, the ABS confirmed that consumer prices rose just 0.4% in the June quarter. In all, inflation rose by just 1% in the 12 months to June, the weakest annual rate in 17 years. This figure was well below expectations, with predictions ranging as high as 1.5% in the lead up to the announcement.

In the short term, these lacklustre inflation figures should increase the pressure on the RBA to cut interest rates, perhaps as early as next month.

At 1.75%, the cash rate is already at its lowest level on record. Yet it’s widely tipped that rates will drop again in the coming months, as the RBA bids to boost inflation, while also applying pressure on the Aussie dollar.

But can the RBA truly hope to ‘tame’ weak inflation? At this point, it seems unlikely. Annual inflation has steadily fallen over the last eight quarters, despite a rash of rate cuts in the past 18 months.

Keep in mind that the RBA’s inflation target rate sits between 2–3%. So it’s a long way off that target at present. To even approach the upper end of that figure, you’d imagine the RBA would need to slash rates several times over. And even that comes with no guarantees, as the effects of rate cuts on inflation have been negligible over the past two years.

Will the RBA cut rates in August?

It’s certainly plausible that the RBA will follow through with a 0.25% rate cut. Market consensus has shifted recently, with bets on a cut dropping from 70% to 50%.

Yet whether it takes place in August, September, or even October is moot. What matters is that the market not only expects it, but that it anticipates further cuts this year as well. As Capital Economics chief analyst Paul Dales notes, ‘We believe that continued low underlying inflation will prompt the RBA to eventually reduce rates to 1%.’

One way or another, the prospect of rates hitting 1% promises to make the second half of the year very interesting for investors.

On the ASX, any rate cut is likely to have a positive effect on shares. We can expect to see buoyed sentiment across the market should a rate cut fall early next week.

If market analysts are right, and rates fall to 1% by year’s end, it would be an extremely bullish development for stocks. Not least because cheap borrowing rates would enable companies to pursue a strategy of showering investors with rewards.

Yet the property market will hold even greater interest in the months ahead.

Very little has changed on this front for a while. Prices in high growth areas continue to surge, despite some downbeat assessments over unit/apartment oversupply.

Elsewhere, growth is either low and stagnant or non-existent (in the form of declining prices).

What would a 0.25% rate cut do for property prices? Moreover, what would a cumulative 0.75% rate cut (to 1%) do by the end of 2016?

In short, it’d boost demand and borrowing, leading to further upward pressure on property prices.

But here’s where we begin to encounter the potential problem with ‘deflationary interest rates’.

What do we mean by that term? Simply, we’re referring to a market condition in which consumers (or borrowers) expect lower interest rates in the future. As a result, they put off or delay spending (or borrowing) on big ticket items — like houses.

With investors expecting several rates cut by the end of the year, homebuyers will need to tread delicately over the next five months.


On the hand one, even a single rate cut would boost overnight demand for new home loans. But not everyone would take the bait. Other investors may choose to hold off on borrowing to take advantage of lower borrowing costs in the months ahead.

Of course, not all property markets are created equal.

Because Australia has a two-speed property market, with unequal price growth, holding off on buying makes more sense in some places than others.

For instance, if you waited another five months to take out a home loan in anticipation of further cuts, you could negate some of your gains as prices rise higher while you sit on the sidelines. A rate cut in August might spur prices to grow another 3% year-on-year in Sydney, which could derail gains you might have made by holding off in anticipation of a second rate cut.

Naturally, though, this would primarily apply to high growth areas.

Yet delaying borrowing in anticipation of further rate cuts could play a much bigger role in low growth areas. Investors and homebuyers in Adelaide, with comparatively stagnant prices, would potentially gain a lot by waiting for further rate cuts. Prices are unlikely to climb dramatically in the next five months, which would allow would-be buyers to reap the benefits of lower borrowing costs.

Of course, none of this is set in stone. We can’t predict how high or low property prices will trend — or where. Nor can we predict with any certainty the trajectory of interest rates, despite market expectations.

But it does give you something to think about as the year unfolds.

Either way, the economy is heading into uncharted territory. If the interest rate deflation mindset takes hold of the economy, we could, in theory, see RBA attempts to boost the economy peter out. What’s more, if businesses take on the same mindset, the RBA might start to feel a little queasy. Business investment and hiring could decline, adding even more pressure on the economy.

It’s not a situation the Aussie economy is familiar with, as we’ve never anticipated a spate of rate cuts in an already record low interest rate environment.

Now that we’re entering a period in which we can realistically expect rates to fall another 0.75% over the next five months, we find ourselves in uncharted territory. Time will tell how the market reacts to it.

Mat Spasic,

Contributor, Markets and Money

PS: Next week, the RBA will convene to decide whether to test the record low interest rate of 1.75%.

As Markets and Money’s Phil Anderson says, interest rates are likely to remain low for a long time to come.

In his latest report, ‘Why Interest Rates Could Stay Low for the 21st Century’, he warns that you won’t be able to rely on your savings to fund your retirement. As Phil says, inflation — from low rates — is eating into your savings. You can’t rely on savings accounts or term deposits for your retirement. The regular return on a term deposit has halved in the last four years alone!

That’s why Phil wants to show you the best way to invest in this low interest rate environment. He’s prepared a four pronged strategy that’ll boost your wealth. You’ll learn where to park your cash over the coming decades to potentially profit in the coming low interest rate environment. To download the report, click here.

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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