Interest rates should soon drop

The RBA's board of directors meets on Tuesday to decide the future of interest rates and hence of our own economic well-being. There remain six interest rate cuts. But will it cut?

You could hardly imagine a better time to stimulate the economy by lowering interest rates.

• the decline in real estate prices is accelerating

• Construction should slow down and put some people out of work

• economic growth is below expectations

• underemployment is high

• wage growth is pitiful

• More importantly, inflation is lower than what it should be

Consumer price inflation appeared this week and has not yet managed to erase the bottom of the target range. Inflation is badumed to be at least 2%. But that's 1.8%.

Despite the impressive list of reasons to cut interest rates, experts expect the RBA to do nothing Tuesday. People who rely on inaction have a good track record – the Reserve Bank has left interest rates alone for two-and-a-half years.

HOW INTEREST RATES ARE DETERMINED

The Reserve Bank sets interest rates to grow the economy at the right pace. But it does not directly target economic growth. Instead, it targets inflation (the speed at which prices rise).

Experience has shown us that if we aim for inflation between 2 and 3% per year, the economy is developing better.

How does the RBA affect inflation? By increasing and lowering interest rates. This is the "monetary policy". When the RBA cuts interest rates, inflation is expected to rise. Inflation should fall when it will raise interest rates.

Interest rates affect inflation because of savers and borrowers.

If you raise interest rates, savers save more, while borrowers borrow less. Both entail a reduction in economic expenses. When economic spending is lower, firms tend to lower their prices.

This is how rising interest rates leads to a drop in inflation. This works in reverse for the interest rate cuts.

WHAT'S THE PROBLEM?

The biggest problem now is that inflation is below the ideal limit. As shown in the graph below, it is not in this range of 2 to 3%. It is not long ago. It is no coincidence that wage growth is weak and that unemployment has improved only slowly.

Normally, the answer would be obvious: reduce interest rates. Just cut them! But the interest rate is so low that the Reserve Bank is afraid to reduce it.

Interest rate reductions are normally 0.25%. Australia's official interest rate is 1.5%. The RBA can cut six more times before the interest rate reaches zero.

It is natural that if you have only six bullets, you become nervous to shoot them. The RBA accumulates its ammunition. But he can not afford to leave things too late.

If we are overwhelmed by a recession and there are still interest rate cuts, that will have failed. It is better to keep the enemy at bay than to let the threshold pbad before reacting.

PRICE OF THE HOUSE

In the past two years, the RBA has been reluctant to cut rates, fearing that home prices will rise to even higher levels. But at this point, does the excuse make sense?

Housing prices seem to be in such a steep decline that it is hard to imagine a reduction of 0.25 percentage points, or even 0.5 percentage points, on the other hand. More likely, the falls would be a little slower and orderly.

THE SAVIOR

If there is a valid excuse for waiting to reduce rates, this could be the next federal election. We will go to the polls in May. There are only three and a half months left. The election is likely to create costly promises on both sides as Bill Shorten and Scott Morrison vie for our affection. If Mr. Shorten agrees to refrain from modifying negative rates before housing prices have stabilized, this could also justify the inaction of the RBA.

All of these promises may be enough to revive the economy and bring back a little more inflation.

If this is the case, the RBA could obtain a stay. But if, after the elections, nothing has changed, the RBA should be ready to use ammunition. For all our good.

Jason Murphy is an economist. Continue the conversation on Twitter @jasemurphy