Low rates a short-term fix
The positive reaction to the 0.25 per cent reduction in the official cash rate to 2.5 per cent per annum reflected relief that the problems of a slowing economy, rising unemployment and sagging investment confidence were being acted upon. But with official estimates of a rise in inflation to as high as 2.5 per cent per annum, other effects of this action could be missed.
Lower interest rates will complicate the already difficult task of reducing the federal deficit, let alone bringing it back to surplus.
The hope is that the lower exchange rate likely to result from reduced interest rates will increase company profitability and corporate tax collections. Offsetting this, however, will be the higher cost of defence and other capital equipment purchases and lower tax collections from fixed interest investors.
Lower interest rates will also result in higher age pension outlays because of pressure to reduce pensioner deeming rates. This deeming rate is used in the income test calculation for age pension entitlement and is set at 2.5 per cent per annum for the first $45,400 (single) or $75,600 (married couple combined) and 4 per cent thereafter.
Soon it will be very difficult for retirees to find safe investments yielding 4 per cent per annum or more. Traditionally the deeming rate has been set slightly below rates obtainable with safety in the market. After this week's action, pressure will be on pensioners to get rates equal to the deeming rate.
Higher yields are available on shares but they involve greater risks for retirees now prices have risen more than 20 per cent in the past year due to the hunt for yield.
The prospect of a slowing economy adds to the uncertainty of investors without shares. While the obvious and simplest way to react to lower investment returns is to draw down capital, there are limits to how quickly this can be done. Drawing down assets to live can increase age pension entitlements and therefore low interest rates for a long period will increase the call on government revenue.
If inflation does rise to 2.5 per cent per annum due to a falling exchange rate, this will be the first time for many years when there will be no positive incentive in real terms to save.
The view has been that real rates of return of around 3.5 per cent are needed to provide tangible returns for investors, including superannuation funds. Australians will ultimately be better off if low interest rates are only a temporary measure to help the economy.