Reserve Bank interest rate cut just the beginning

Australia's lowest ever Reserve Bank cash rate - 1.5 per cent - is about to be consigned to history. Governor Philip Lowe made it clear he plans to cut it in two weeks' time. The money market cash rate (from which all other rates derive) will then fall to 1.25 per cent.

After that, if betting in the market is right, he will cut the cash rate to just 1 per cent by Christmas. Speaking in Brisbane, Lowe said the Reserve Bank board was of the view that: Inflation was likely to remain low relative to the target, and that a decrease in the cash rate would likely be appropriate.

A lower cash rate would support employment growth and bring forward the time when inflation is consistent with the target. Given this assessment, at its meeting in two weeks' time the board would consider the case for lower interest rates.

The bank is forecasting a tick up in economic growth from the present 2.3 per cent to 2.75 per cent by the end of the year and a fairly steady unemployment rate. But here's the thing. He was keen to emphasise that those forecasts only applied if he cut rates twice this year - that's twice, before the end of the year.

He is planning

to do

it because the economy is weak, much weaker than his political masters suggested during the election campaign. Consumer spending is "unusually soft".

Over the past three years, household disposable income has increased at an average rate of just 2.75 per cent. This compares with an average of 6 per cent over the preceding decade.

As this period of weak income growth has persisted, it has become harder for households to dismiss it as just a temporary development - as something that will pass quickly. The lower rate of income growth has also made it harder for households to pay down debt. The end result has been that many people have decided to adjust their spending plans.

It isn't much good cutting interest rates if mortgage rates don't follow. That will be up to the banks. But until this week, even if they had passed it on, there would have been so many would-be borrowers it wouldn't have helped.

That's because, whatever the interest rate and whatever a would-be borrower's ability to make payments, banks have generally refused to lend to anyone who couldn't cope with a rate of 7.25 per cent.

CoreLogic figures show there are more properties for sale on the market than at any time since 2012, and few buyers. It's been the doing of the Australian Prudential Regulation Authority - one of the Reserve Bank's sister organisations.

It regulates banks and super funds and other institutions in order to keep the financial system stable.

In December 2014 it directed the institutions it supervises to impose serviceability assessments that incorporated a buffer of at least two percentage points above the loan product rate they were offering and a minimum floor rate of at least 7 per cent.

That meant that if new mortgage rates were 5 per cent, as they were at the time, the lenders had to satisfy themselves that the borrower could cope with 7 per cent. As new mortgage rates fell to 4.5 per cent they still had to satisfy themselves that the borrower could cope with 7 per cent.

APRA's directive stated that "prudent practice would be to maintain a buffer and floor rate comfortably above these levels", meaning that in practice most lenders wouldn't lend to anyone who wasn't able to cope with the mortgage rate climbing to 7.25 per cent, no matter how unlikely that was becoming.

On Tuesday this week, a few hours before Governor Lowe delivered his speech, it wrote to the institutions again, telling them.