Dr Jonathan Reeves

So, the Reserve Bank of Australia has decided not to cut interest rates. The RBA has kept its cash rate at 4.25 per cent, defying expectations of a third rate cut in a row. That is a bit of a surprise, and it may cause further falls in the housing market.

the decision was always going to be finely balanced, but on the face of it, it does seem a little unusual, because inflation is declining giving room for a cut, which would also bring down the dollar. Without doubt the RBA do seem to have been overly concerned with inflation right now, and not the high level of the dollar. Indeed, it is surprising that the RBA isn’t worried about the exchange rate. The car industry – and indeed all manufacturers – are finding it difficult to export, even though mining is booming. Other sectors such as retail, tourism and education are also feeling the effects of an inflated exchange rate.

The RBA said that in Australia economic growth was ‘close to trend’ –  indicating that they felt it was performing as they wished –  and that while the unemployment rate increased slightly in the middle of the year, it has been steady over recent months.  The RBA cut the official interest rate, by 25 basis points each time, in both of its last two meetings.

This decision may mean that the housing market further unwinds and price falls increase. Not only will the cost of borrowing not go down, but it is likely to increase the exchange rate, as the dollar goes up against all major currencies. That in turn may have the effect of further squeezing sectors such as manufacturing, retail, tourism and education, putting pressure on jobs, and downward pressure on house prices.

The RBA says CPI inflation has declined as it expected, because the large rises in food prices resulting from the floods a year ago have been unwinding. The RBA has forecast that inflation will fall further over the next quarter or two, and over the coming one to two years the Bank expects inflation to be in the 2–3 per cent range.

However cutting rates and tolerating a higher level of inflation could be the key to helping Australia navigate the turbulence of the global economy. Australian inflation is not high by current international comparisons and does not pose as much of a threat to our economy as record highs for the currency. Given two ‘evils’ – inflation or an appreciating currency – it is clear that our current level of inflation is by far the lesser evil of the two.

Officially amending the inflation target would take the wind out of ongoing expectations of a rate rise and could prompt some easing in the value of the Australian Dollar, down from what are still historically high levels.

Dr Jonathan Reeves is a financial economist at the Australian School of Business.