Reserve Bank Governor mulls road ahead.

Cash is still king. Inflation goes missing.
Reserve Bank Governor speech; Banknotes; Outlook for interest rates

Speech from Reserve Bank Governor: Governor Philip Lowe delivered a speech, “Remarks at Reserve Bank Board Dinner”.

Banknotes on issue: The Reserve Bank says “the stock of banknotes on issue, relative to the size of the economy, is close to the highest it has been in 50 years.” On average the amount of cash in the economy translates to $3,180 per person.

Interest rates: References to the job market far exceeded those of inflation in the latest interest rate decision.

Speeches from the Reserve Bank Governor can influence interest rate and currency markets.

What did he say?

Rate cut

• The Reserve Bank Governor covered a lot of ground in last night’s speech. Governor Lowe spoke about the background to the latest rate cut. He also spoke about the up-coming (Friday) release of the Financial Stability Review. And Governor Lowe mulled about the demand for banknotes in Australia.

• In terms of the latest rate cut, Governor Lowe put the rate cut in a global context. Simply, investors across the globe are sitting on the sidelines, waiting for the US-China trade deal to be concluded. There is a significant supply of savings but a paucity of investment happening.

• “Like many things in economics it comes down to supply and demand. When the global supply of savings is high relative to the global demand for funding to invest in new capital, the price of savings – or the global interest rate – is going to be low. There are certainly other factors at play as well, but savings and investment decisions are at the heart of the issue.”

• So central banks across the globe have been cutting rates. And Australia is part of that trend. The Governor has remarked before that if we don’t cut rates in line with other countries then the Aussie dollar may lift, reducing the competitiveness of Australian goods and services.

• At home, the RBA says that economic conditions are improving: “the economy appears to have reached a gentle turning point”. But while conditions are improving and expected to keep improving, progress remains slow. So the Board decided to cut rates again.

• “We are seeking to make more assured progress towards both full employment and the inflation target. We still expect to make progress on both fronts, but that progress is slower than we would like.”

• The Governor makes the point that “monetary policy still works”. But the Governor also notes that “the Board recognises that the impact of monetary policy on the economy has changed over time, and that there can be some undesirable side effects from low interest rates.”

• In other words, there are winners (borrowers) and losers (depositors) from rate cuts. But the belief is still – in a broader or macro sense – that lower rates “promote the collective economic welfare of the Australian people.”

Financial Stability Review

• The Governor makes a number of points. Governor Lowe says that there is a lot of uncertainty across the globe. But despite this “credit spreads are low and asset prices are generally high. At our meeting today we talked about the possibility that a shock somewhere in the global system could cause a recalibration, leading to a disruptive repricing of risk.”

• Governor Lowe also reflects on the strength of the financial system and tightening of lending standards.

• Also Governor Lowe notes that consumer finances are well positioned (have substantial buffers) despite high debt levels: “the balances in mortgage offset accounts and redraw facilities amount to 16 per cent of outstanding housing debt. This is equivalent to around 2½ years of required mortgage payments at current interest rates.”

• One are to watch is Western Australia where there has been a lift in the number of borrowers where their current loan balance exceeds the value of their property.

Banknotes on issue

• The Governor also said that a new $20 note will be issued on October 9. In this context Governor Lowe indicated that demand for banknotes remains high. In fact, “the stock of banknotes on issue, relative to the size of the economy, is close to the highest it has been in 50 years.”

• So where are all the notes? The RBA “estimate that around a quarter are used to make legitimate day-to-day transactions within Australia. It also appears that between half and three quarters are held as a store of value in safes, under beds and at the back of cupboards, both here in Australia and elsewhere around the world. We estimate that a further 4 to 8 per cent are used in the shadow economy, either to hide transactions from the tax office or to undertake illegal transactions. Finally, it appears that between 5 and 10 per cent of banknotes are either simply lost, maybe at the beach, or destroyed, perhaps in a natural disaster.”
Latest economic data: Banknotes in circulation

• The value of all banknotes in circulation stood at $81.02 billion at the end of September, up 4.4 per cent over the year, the slowest growth in six months.

• The value of all $100 notes in circulation stood at $36.80 billion at the end of September, up 5.4 per cent on a year ago and the fastest rate in seven months. In smoothed terms, annual growth of $100 notes in circulation is the fastest in 2½ years.
Latest interest rate decision

• The importance of the job market in interest rate decisions was highlighted yesterday. There were 17 references to the job market or wages in the interest rate decision. By contrast ‘inflation’ was mentioned just eight times.

• The Reserve Bank still conducts monetary policy with the aim of keeping annual inflation between 2-3 per cent over time. But underlying inflation (trimmed mean) has been below the target for 3½ years. With inflation contained, the RBA is more confident of running the economy at a faster pace. In fact the new estimate of “full employment” is an economy with a 4.5 per cent jobless rate rather than 5 per cent.

• The aim of the RBA is to run the economy at a faster rate, boosting jobs and lowering the jobless rate, with the tighter jobless rate serving to lift wages and prices.

• Given that the stock of debt exceeds deposits, the Reserve Bank believes that rate cuts still work to boost borrowing, spending and employment.

• But the actual number of consumer depositors substantially exceeds the number of those with loans. CBA reports that it has 1.6 million home loan customers and 6 million savings and investments customers. NAB reports 930,000 home loan customers and 3 million savings customers. The ANZ says it has five times more savings and investments customers than home loan customers. At low interest rates these depositors may be more reticent to spend.

• In terms of borrowers, some will respond to rate cuts by trimming repayments to unleash spending power. But others will elect to maintain instalments and get ahead in reducing outstanding debt. If more people elect to maintain loan repayments, there may not be the boost to spending as policymakers expect.

• Further, if Aussies view super-low interest rates as a sign of economic weakness, again there may not be the same boost to spending as policymakers expect.

• In coming months, there will be much debate on the effectiveness of rate cuts.

What is the importance of the economic data?

• On the first trading day or each month, the Reserve Bank releases data on the amount of banknotes in circulation. The data may provide guidance on liquidity in the economy and saving behaviour of consumers.
What are the implications for interest rates and investors?

• Aussies tend to value $100 notes for their “store of value”. And, as the RBA Governor says, Aussies may accumulate the cash and store the notes in “safes, under beds and at the back of cupboards.” A lift in demand for $100 notes has occurred in the past in uncertain times, such as the global financial crisis. The lift in demand for $100 notes in recent months needs to be watched.

• The Reserve Bank Governor still believes that rate cuts work, despite the super-low nominal levels. And as long as that belief is held, further rate cuts are possible.

• Commonwealth Bank Group economists expect the next rate cut to be delivered in February 2020. Stable rates over the next two meetings will give Board members the opportunity to see the impact of previous rate cuts on the economy.

Published by Craig James, Chief Economist, CommSec