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Reserve Bank of Australia has the primary responsibility to conduct the monetary policy in Australia. RBA has adopted the inflation targeting monetary policy for long. Cash rate is the major tool for Australia’s monetary policy. The key objective of the monetary policy stance is to maintain a stability in the price level of the economy, generate maximum employment and improve the welfare and standard of living of the Australians.
Overtime the cash rate has changed significantly ranging a highest of 17.5% in 1990 to a record low level to 1.5% in 2019. The decisions of changing the cash rate is taken by the RBA Governor and the Board by considering both the domestic and the global economic conditions.
RBA can change the interest rate that in turn affects the aggregate demand. The impact of cash rate change can be illustrated by the following diagram.
Ms
Interest rate
SRAS
Price level
Ms’
P1
AD’
r0
P0
Md
AD
r1
Q1
Q0
Quantity of money
Real GDP
(b) AD- AS model
(a) Money market
Due to accommodative monetary policy with lowering the interest rate, the money supply curve shifts to the right from Ms to Ms’. As a consequence, the interest rate comes down from r0 to r1. A fall in domestic interest rate will boost consumption and business investment activities that in turn shifts the aggregate demand curve from AD0 to AD1. The equilibrium real GDP and equilibrium price level will increase as shown in figure (b). (Carbaugh, 2009)
The following chart shows how the cash rate has evolved in Australia since 1990. The data for the cash rate is collected from the RBA website.
https://www.rba.gov.au/statistics/cash-rate/
Let us analyse the key considerations for the cash rate decisions by reviewing the information in few of the RBA meetings:
8 November 2006
In the meeting held on 8th November 2006, RBA has decided to increase the cash rate to 6.25, that is a rise of 25 basis points. The rate hike move was taken at the background of high inflationary pressure in the domestic side and the continues expansion of global growth in the international front. The world economy is growing at a solid pace and expected to grow at an above average pace even in 2007. The continued expansion of global economy leads to increase the commodity prices resulting a higher export revenue for Australia.
The Board has keenly considered the adverse impacts of the drought in terms of limited supply from rural produce, reduction of income of the farmers that may likely put a downward pressure on the food stuffs. Since it is a temporary phenomenon it will not affects the inflation outlook in the medium term. Over all the economic conditions are healthy – labour market performance is impressive, domestic demand is growing steadily and the pace of credit growth remains strong. The value of Australian dollar has increased against USD in foreign exchange market. The value of AUD has reached to US$77 cents over the last month. Australian dollar has also moved higher against Yen with a current rate above 90 Yen. Strong economic fundamentals and the higher commodity prices have significantly increased the expectations of tightening monetary policy in the months ahead. (RBA, 2006)
Combinations of such factors is expected to put an upward pressure on domestic inflation. The inflation rate in the September quarter was already 3% - moreover a noticeable increase in headline inflation is observed in the economy. Thus, the Board has considered the economic environment is risky for the inflation rate exceeding 2-3% over the medium term. RBA has already increased the cash rate twice in this year but the risk of inflation exceeding the target level of 2-3% has remained significant. The Board has believed that, tightening monetary policy stance with the rate hike may bring the inflation rate back towards 2.5% gradually. The Board was in little dilemma regarding the merits of increasing the cash rate by 50 basis points but finally they have judged that 25-basis point rise will provide adequate flexibility in the coming months, if required. (RBA, 2006)
8 October 2008
In the meeting held on 8th October 2008, RBA has announced to reduce the cash rate by 100 basis points. The cash rate comes down to 6.0 percent after this meeting. 2008 is one of the most turbulent periods in global economic history. This is the period when the worst Global financial crisis hit almost all the countries across the world though in varying magnitude. The world has observed the failure of large financial institutions across United States and Europe. The financial market in Australia is also impacted with a high degree of pessimism. The financial landscape in several advanced countries have changed dramatically. Though Australia has performed far better than many of its peers and remains resilient, the economy is undoubtedly severely strained.
The financial crisis has been reflected across the financial market with a fall in bond yield. Equity market has fallen significantly. The fall in share price in major markets has gone back to 2004 level. The failure of Lehman Brothers acts as a catalyst that significantly increased the perceived risk among other financial institutions. Turing to the foreign exchange market, the Board members have observed that Australian currency has remained volatile since last month rather fallen against all other currencies of its major trading partners. Labour market conditions in the domestic economy was not much favourable as the slowing of employment growth has cropped up since the last month. (RBA, 2008)
As far as the global economic conditions are concerned, US was worst hit by the global economic meltdown. Turing to the conditions of its major trading partner China, industrial production has slowed down and came down to the lowest rate in the last five years. Similar patterns of economic slowdown are...