What will be the impact of the latest interest rate reduction?

It came as no surprise that the Reserve Bank reduced the cash rate to 2.5% a couple of days ago. The questions are why did they do it and what will be the result?

The Reserve Bank has been concerned about our two speed economy in Australia.  The mining and resources sector has been booming, while the rest of the economy has slowed down.  It now looks as though we are moving towards a single and slow speed economy as the mining boom ends.  By reducing interest rates, the Reserve Bank hopes to encourage economic growth, particularly in the area of small business.

Unfortunately, it would seem that while lower interest rates have been good for financial markets and home owners with mortgages, lower interest rates have not been reflected in an increase in business confidence.  And of course investors holding term deposits and cash have seen the returns on their investments fall significantly.

More worrying is that low interest rates may be causing a housing price bubble, leading to the possibility of cash flow problems for home buyers down the line when interest rates rise once again.  This situation could be made even worse should unemployment rise with people being forced to sell if they cannot meet their loan repayments.

The non-mining sector of the Australian economy has also been struggling with a high Australian Dollar which not only makes our exports more expensive, but also causes imports to be cheaper, thus making it harder for Australian manufacturers to compete with goods produced overseas.  Lowering interest rates has the effect of weakening our currency.

The Australian Dollar has now fallen about 18% from its peak against the US Dollar, but this is actually a two edged sword.  On the one hand our exports and local manufactures are now more competitive, but on the other hand consumer and business imports are now more expensive, leading to an almost certain rise in inflation.  A rise in the rate of inflation beyond the Reserve Bank’s target range of 2-3% will mean an increase in interest rates as the Bank acts to contain inflation.  This will be good news for investors holding cash and term deposits but bad news for just about everyone else.