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Cash rate’s normal level now only 3.5pc

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The RBA’s cash rate is at a record low, but may be only one percentage point below normal.

It all depends on what you think normal is for the cash rate these days.

Ben Jarman, economist at JP Morgan, thinks the “neutral” cash rate has fallen.

The neutral rate, Mr Jarman says, is the cash rate that’s consistent with low and steady inflation and unemployment.

In the decade or so ahead of the financial crisis in 2008, the cash rate averaged about 5.4 per cent.

But the average inflation rate for that period was near the upper edge of the target band, and unemployment headed lower, leading Mr Jarman to conclude that the neutral rate was really about 5.8 per cent.

That was before the crisis, though.

Since then, two factors have shifted.

One is the widening spread between the cash rate and rates faced by household and business borrowers.

In the wake of the crisis, wholesale funding markets became stressed and regulations have required banks to raise a greater proportion of their funds from deposits.

“This funding mix is more expensive, which has been passed onto rates on mortgage and business loans,” Mr Jarman said in a report on Monday.

For mortgage rates, that has widened the spread above the cash rate by 1.65 percentage points compared with 2007, while the spread for business loans had widened by 2.4 percentage points.

The other factor, which Mr Jarman says is more difficult to measure, is the slower growth in borrowing associated with a given level of interest rates.

Household debt levels reached “saturation” in 2005 and stopped rising as a proportion of income from 2008.

Mr Jarman estimates that mortgage rates are lower than they otherwise would be just to offset the reduced desire to borrow.

He ascribes a further fall in the neutral cash rate of about a quarter of a percentage point to this effect, which he refers to as “deleveraging headwinds”.

Putting the two factors together, Mr Jarman says the neutral level for the cash rate has probably fallen to 3.5 per cent.

And that’s only one percentage point above where is it now.