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Interest Rates Take A Trip Down Under

Australia Deflation May 2016

Image source: Frances Gunn / Unsplash.com

What's going on?

The Australian central bank surprised investors on Tuesday by cutting its target interest rate – the Aussie dollar sold off and Aussie stocks jumped. There are also broader takeaways for global investors.

What does this mean?

Last week, data in Australia was released that showed prices for consumer goods in Australia (i.e. the stuff a typical Aussie would buy, like barbeque tongs…) are actually falling – in other words, deflation is occurring. Australia’s central bank specifically cited the low outlook for future inflation as a major reason for the interest rate cut (remember that low inflation and/or deflation is usually considered to be dangerous for an economy – click here for an explanation). It shows global investors that downward pressure on prices remains strong – and it’s very hard for interest rates to go up in such an environment.

Why should I care?

The bigger picture: Low inflation is a global problem. On Wednesday, the European Commission lowered its inflation forecast for the coming years (remember, despite the better-than-expected economic growth in the first quarter, prices in Europe actually fell). In the US, recent data came out suggesting that the moderate uptick in inflation experienced earlier this year is now reversing. Low inflation (or even deflation) is typically reflective of weak economic growth (i.e. it’s tough to raise prices when there’s not much demand for things) and a cause of future economic headwinds. So, recent news on low inflation / deflation is probably something of a red flag for global economic growth.

For markets: Low interest rates are supposed to ward off low inflation. With lower interest rates, people and companies are supposed to borrow more money and invest it in economically productive things (like buying equipment or hiring workers). How well this strategy is working is debatable, but one of the takeaways from today’s news is that as long as inflation is low, there will be pressure on central banks to keep interest rates low – and that’s true for all countries.

Originally posted as part of the Finimize daily email.

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