Australia Markets open in 6 hrs 33 mins

This is the main driver for a cash rate CUT, and it'll happen soon

Source: Getty Images

The prospect that interest rates will be lowered within the next few months is already starting to impact on the economy.

Here’s how.

Around the middle of 2018, financial markets were expecting the RBA to hike official interest rates to 1.75 or 2 per cent over the course of the next 18 months or so.

If proof was needed that investors and economists can get it wrong, markets are now pricing in official interest rates to be cut towards 1 per cent over the next 18 months.

The about face has been driven by a raft of disappointing news on the economy, most notably the fall in house prices, the free-fall in new dwelling building approvals and a slump in retail spending growth.

Business confidence has also taken a hit and job advertisements have been falling for eight straight months. Ongoing low inflation and increasing signs of a slowdown in the global economy have simply added to the case for this dramatic change in market pricing.

While the RBA is yet to act on this fresh news, with official interest rates having been held steady at 1.5 per cent for the past two and a half years, the change in financial market pricing has seen the Australian dollar fall and the stock market register strong gains.

This is how it should be.

A large part of the interest rate cut scenario and how it would work to improve the Australian economy is via a lower Australian dollar exchange rate.

While changes the Aussie dollar are driven by a lot more than interest rates, they can have a sizable impact on investors flows at least in the short term.

The lower dollar, if sustained, will work to boost the competitiveness of exporters and those local firms competing with importers.

As such, the contribution to bottom line GDP and jobs will be helped in a lower interest rate environment by stronger external trade.

The rise in the stock market is good news for investors as it is providing a partial offset to the slump in wealth coming from the decline in house prices.

It could also be reflecting the market’s confidence of rising profits, an improved cash flow and a lift in private sector business investment that will flow if the RBA cuts interest rates.

Any interest rate cut from the RBA would also help the cash flow of all borrowers, be they in the business sector or householders. This cash would either be used to pay down debt or boost spending, both of which help the profitability of the business sector.

The timing of interest rate cuts remains unclear. After all, the RBA which has for the past year stubbornly expected interest rates to rise, has only just started to soften its view.

Recent comments from RBA Governor Philip Lowe suggested that the health of the labour market and changes in the unemployment rate, in particular, will determine any change in interest rates.

On that score, the unemployment rate has been trending lower in recent times, although it remains well above the level prevailing around much of the industrialised world and indeed, at the level prevailing before the global financial crisis hit.

Suffice to say once the weakness in the economy start to drive the unemployment rate higher, the RBA will lower interest rates. In the mean time, the adjustment has already begun with the Aussie dollar weaker and the stock market stronger as the market starts to factor in lower interest rates, at some stage, through the course of 2019.

Make your money work with Yahoo Finance’s daily newsletter. Sign up here and stay on top of the latest money, news and tech news.

Now read: Shares vs property: which’ll make you the most money?

Now read: Labor’s negative gearing plans will lead to a spike in overseas buyers

Now read: Meet Mia, the new robot who will help you secure a home loan