Why are interest rates so low and how much lower can they go?

Why are interest rates so low and how much lower can they go?

Interest rates in Australia have fallen to record lows in 2019, with the cash rate at a meagre 75 basis points. Low interest rates are not unique to Australia - interest rates around the world are very low and in many cases are the lowest on record. Further easing by central banks is also widely expected. In Europe and Japan, we even have a scenario where investors are actually paying governments to hold their money for them. So why are interest rates so low?

 

Short-term factors

There are both short-term and long-term factors that have driven interest rates lower globally. In Australia, one of the shorter-term domestic factors is weak consumption growth which has largely been driven by very weak wages growth. Consumers are also burdened by very high levels of household debt. Weakness in consumption, which is around 60% of the economy, has contributed to a slowing in GDP growth.

When growth in the economy is weak, this typically means that inflationary pressures are low and therefore interest rates need to be lowered. Another contributing factor to a weak economy and low interest rates is a slowing global economy. Over the past year, there has been a broad-based slowdown in global growth, partly explained by ongoing trade wars, heightened political uncertainty in a number of countries and a slump in manufacturing activity.

 

Long-term factors

There are also structural or longer-term factors that have been shifting global interest rates lower, including globalisation, advances in technology and ageing demographics. Globalisation and advances in technology have resulted in an increase in competition globally. This has put downward pressure on both wages and inflation which has resulted in lower interest rates.

For example, as a result of globalisation, many jobs in both services and manufacturing that were traditionally done in Australia can now be outsourced to Asia at a lower cost. This means that wages and prices are less likely to be bid up than they were previously. Another structural factor leading to lower interest rates is ageing populations in advanced economies. An ageing population results in a decline in labour supply and lower economic growth.

 

What does the future hold?

The important question for both borrowers and savers is, what will happen to interest rates in Australia? The RBA has suggested that a cash rate of around 25-50 basis points is likely to be the lower bound. After this point it is unlikely that banks will be able to pass on the cash rate cuts to borrowers since retail deposit rates will not be lowered below zero.

What can the RBA do if the cash rate reaches the ‘lower bound’ but the economy remains weak? In this situation, the RBA would prefer that the government inject fiscal stimulus such as tax cuts or spending on big public infrastructure projects. However, if this fails to materialise, the RBA has suggested that it will need to resort to ‘unconventional’ monetary policy measures, including quantitative easing. This would likely involve the RBA initially purchasing government securities, leading to lower long-term interest rates and potentially putting downward pressure on the Australian dollar.

While it is unclear whether the RBA will have to resort to unconventional monetary policy measures, investors are in agreement that interest rates will remain low for years to come.
 

Alexandra Clarke
Senior Analyst