Interest rate cuts may have provided a temporary reprieve to the economy but at the cost of inflating long-term economic risks.
Remember the last time you waited in line at your favourite café, thinking about the RBA’s decision to change interest rates? What impact would it have on your decision to buy that extra croissant?
If you said yes you’re either lying or you really love Economics!
Now think about the phrase “It’s Corona time”.
Chances are, you’re thinking of consumers going absolutely crazy over toilet paper at Woolies, while a catchy TikTok jingle plays in the background.
As you may have noticed people aren’t always rational, especially when it comes to spending. In particular consumers often make decisions in the spur of the moment acting on Keynesian “animal spirits”.
With this in mind, the likelihood of a global recession seems inevitable as the Coronavirus epidemic displays material symptoms. Furthermore as more countries such as Italy implement travel bans, in line with countries such as China, South Korea and Iran, there will be a sharp dip in global trade.
In order to counteract this economic drag – over the past fortnight, central banks around the world have cooperated to reduce interest rates with the RBA and Federal Treasury being the latest to do so.
Last Tuesday the Reserve Bank of Australia decided to cut interest rates by 25 basis points to a record low of 0.50 percent. Bear in mind that prior to the GFC the RBA had reduced interest rates over three consecutive months to 0.75 percent.
As Governor Phillip Lowe explained “ The coronavirus has clouded the near-term growth outlook” and the associated “uncertainty is likely to affect domestic spending”[i].
The coronavirus has clouded the near-term growth outlook”
But keeping aside the Coronavirus shock the RBA outlook supports a return to an improving trend due to high infrastructure spending, lower exchange rates, positive resource sector forecasts and recoveries in residential construction and household consumption.
Here is where the issue arises – while Interest rate cuts may have provided a temporary reprieve to the economy they come at the cost of inflating long-term economic risks.
Conventional Monetary Policy – One in the chamber
If you have taken any introductory Economics courses, you may be familiar with the concept of aggregate demand and supply shocks.
In current circumstances the Coronavirus epidemic is causing both shocks simultaneously. Aside from the supermarket run, consumers aren’t buying the same amount of goods and services as they usually would leading to a drop in aggregate demand.
This is coherent with reduced consumer confidence with people holding unemployment expectations and expecting strong devaluations in investments. If you have been following market reports you may be aware that on Monday US markets dropped by 7.6%, the largest drop since the GFC. The ASX similarly by around 400 points from an opening value of 6216.20 points on Monday with further falls expected.
Now as can be seen in the graph below within Q1 of 2020, consumer sentiment is below levels that it was in 1980.
Instead of spending money on your daily coffee, you decide to save your money for a rainy day. Multiply this decision by hundreds of thousands of people and we can clearly see a sharp decline in consumption – an aggregate demand shock.
On the supply side people are becoming more hesitant to visit public places such as restaurants, schools or even travelling by public transports. The net result can be seen below – a sharp increase in household savings.
At its core, the whole premise of reducing interest rates is to give consumers more money to spend, similar to what the Rudd-Gillard government stimulus package did during the GFC. However if customers aren’t going out to spend either way, reducing interest rates will have likely little to no effect.
Furthermore reducing interest rates won’t contain Coronavirus concerns and with one last rate cut left in the chamber, the RBA may need to look at unconventional monetary policy methods, alongside fiscal policy.
A brief note on Unconventional Monetary policies
There are four unconventional monetary policy decision which can potentially be employed by the RBA which include: negative interest rates, Extended liquidity operations, quantitative easing and forward guidance.
Addressing these questions at last year’s Australian Business Economics dinner, Governor Lowe stated that negative interest rates are “highly unlikely” – drawing upon the differences of Greece and Japan’s economic positions prior with a period of deflation.
negative interest rates are “highly unlikely” – Phillip Lowe, 2019
Similarly extended liquidity operations and forward guidance are not yet in discussion with the Federal government stimulus package expected to target Coronavirus hit industries.
That leaves quantitative easing. “Current thinking” by the RBA is that QE will be considered if the cash rate reaches 0.25 percent, as interest paid on surplus balances at the RBA will be effectively 0.
The issue with employing any of these is the possible side effects associated with them, such as changing the incentive structures of financial systems or allowing unproductive ‘zombie”[i] firms to survive.
It’s the equivalent of building a light rail transportation system to reduce congestion, but accidentally increasing travel times.
The Fiscal Policy juggernaut
In light of weakened global demand, as well as unpredictable consumer spending. Fiscal policy may be able to provide a caffeinated hit to combat Coronavirus fatigue
The Federal government has announced a multi billion dollar stimulus package with $2.4 billion allocated to health related services to contain the Cov-19 strain. Furthermore there is expected to be a focus on small business support – with banking institutions already having passed rate cuts on.
A part of the package also aims to promote infrastructure development and ensure that bushfire afflicted communities can make a recovery to normal, however how successful this package is will depend strongly on whether consumers will save or spend their money.
Therefore next time you are lining up at your local café and wondering whether you should buy the extra croissant.
Better yet, buy all the croissants in the store because “it’s Corona time”.
[i] Unconventional Monetary Policy: Some Lessons From Overseas
Charts sourced from RBA March Chart pack: