Economy offers plenty to cheer about
Good news: The overall impact of lower interest rates is likely to be positive.
Judging by the enthusiastic sharemarket and public reaction to the 0.25 per cent reduction in the official cash rate, the Reserve Bank has achieved the desired effect of injecting needed confidence into the economy.
The decision clearly recognises that Australia can no longer afford to maintain cash and fixed-term interest rates above the low levels applying in other major economies. For Australia not to reduce its attraction to yield-seeking overseas investors would have created upward pressure on our currency when the falling terms of trade require a lower exchange rate to maintain activity.
Following this week's reduction, financial markets and investors are anticipating a further 0.25 per cent fall in the official rate to 2 per cent. At this stage, there is little speculation of further cuts but other major economies have been operating with rates below 1 per cent for several years. Self-funded retirees and cashed-up investors will be hoping our interest rates don't fall much further but the pressure worldwide except in the US and parts of Asia is for continuing very low rates as inflation levels fall.
How the economy performs from now on will still be crucially dependent on whether the slide in commodity prices has halted. The general consensus is world economic growth is likely to continue to slide. Domestically, political obstacles are hampering efforts to bring the federal deficit down, resulting in both fiscal and monetary policy stimulating demand.
While there is still room for continuing deficits to be funded by increasing debt levels without adversely impacting on the country's credit rating, there are nevertheless significant challenges ahead to fund needed infrastructure outlays without public asset sales. The biggest challenge for the economy in this context is replacing the large capital outlays that were part of the minerals and energy boom.
Even with the dollar 30 per cent lower from previous peak levels, commodity prices in Australian dollar terms are about 70 per cent or even lower than previous levels. This presents major long-term problems for both the companies concerned and federal and state governments. Only a small part of the fall in revenue from lower commodity prices is offset by lower operating expenses, meaning that operating profits fall by a much larger percentage than revenue.
State royalties decline in the same proportion as revenue while taxable company profits fall by a greater percentage. As a result, both levels of government benefit from a lower exchange rate. All things considered, the overall impact of our lower interest rates will be positive.