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Here's why the Reserve Bank needs to cut rates

RBA interest rate cuts are needed. Source: AAP

Many people misunderstand my concern about falling house prices and the coincident call for the Reserve Bank to cut official interest rates.

Any interest rate cut that the RBA may yet deliver should not, and certainly will not, be aimed directly at supporting house prices.

On the contrary – future interest rate cuts should be directed at supporting the economy more generally at a time when the house price falls threaten to erode household wealth, consumer spending and the economy more generally.

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The house price declines in the current downturn are much what I was forecasting a year ago. The issues surrounding the price falls are being compounded by the recent acceleration of the decline, the historic collapse in housing auction clearance rates, the escalation of the bank credit freeze and the on-going problems with low wages and inflation that are all creating an environment that will hit the economy into 2019.

While a recession in Australia is still unlikely, very unlikely in fact, there is a growing risk the unfolding mix of events will hit the economy hard.

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The destruction in household wealth from the falls in house prices alone is now about $300 billion. Add to this another $100 billion of wealth destruction from the recent fall in the stock market, and a climate of severe weakness in consumer spending is front and centre in the outlook for most credible forecasters.

This is why the RBA would be wise to cut interest rates.

To reiterate – the wisdom in cutting interest rates is not to reflate house prices. On the contrary, macro-prudential rules and the tight credit conditions for mortgages should remain in place if interest rates are lowered.

Lower interest rates matter because they would help guard against the fall out from the unfolding household wealth destruction which would see annual GDP growth slowing to around 2 per cent, it would see the unemployment rate get back up towards 6 per cent and inflation would fall from already near record low levels.

Most analysis on interest rates makes the mistake of focusing on the housing market if a rate cut is delivered.

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Ignored is the fact that the business sector has over $940 billion of bank debt and another half a trillion or so in corporate debt.

Lower interest rates would free up cash flow on this business debt by lowering debt service costs. This would not only help business to invest and hire more, it would underpin new business investment as the interest rate threshold for expansion is lowered.

What’s more, interest rate cuts would likely see the Australian dollar fall, especially when the US is in a clear cycle of interest rate increases.

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A lower Aussie dollar would give the export sector an extra boost, adding to economic growth and national incomes and would provide an offset to the looming weakness in household spending. It would also help local businesses competing with aggressive low cost importers as the price of imported items rose.

The housing market is important in itself but more importantly, in the way it risks dragging the rest of the economy down with it.

It is this latter point where policy should be directed for the sake of economic growth and stability.

With inflation locked in at a remarkably low rate, the most effective policy change would be to cut interest rates to shore up the business sector in the risky time.