The Reserve Bank has not ruled out further interest rate cuts. Near-term growth and inflation forecast have been downgraded, albeit mildly while the central bank remains optimistic about the longer-term prospects for the domestic economy.

The RBA has warned that risks are weighted to the downside. Annual GDP growth forecasts in June 2012 have been cut from four per cent to 3.5 per cent. Underlying inflation is tipped to ease to 2.25 per cent in June 2012, down from 2.5 per cent

The Reserve Bank has weighed into the debate on bank funding costs. The central bank highlighted the increase in wholesale borrowing costs and the shift in the composition of bank funding to shift to household term deposits – “which was now at its highest level since 1998”.

What does it all mean?

The overall tone of the latest RBA statement is one of cautiousness while highlighting the downside risks to the domestic economy. In addition, the central bank did make clear reference to the exacerbated slowdown in the eurozone and the fact that the growth in emerging economies is likely to be a little softer than previously expected. However, while the Reserve Bank is cautious about the outlook, it did make reference to the improvement in the economic landscape over the past couple of months – and that is the likely reason why interest rates were not cut this week.

Interestingly, the Reserve Bank is still open to the idea of further rate cuts, though it seems to be more a matter of timing. The likelihood of any further rate cuts will depend on the shifts in domestic inflation and the ongoing eurozone debt crisis.

The recent media discussion on bank funding costs has prompted the Reserve Bank to shed some light on the debate. The central bank noted that the composition of bank funding has continued to shift to household term deposits, which was now at its highest level since 1998. However, given the increase in competition for deposits, the Reserve Bank was well aware of the “increase in the spreads on term deposits”. In addition, the spread on wholesale funding had “also risen due to an increase in the compensation required by investors globally”, while there was an “increase in the cost of foreign exchange hedging” due to the recent volatility.

What are the implications for interest rates and investors?

The Reserve Bank is clearly focusing a lot more attention on global conditions, particularly given the concerns surrounding Europe. It is important to point out that the longer it takes to find a solution to the European debt crisis the more heighted the risks are for the global economy.

From a domestic perspective, it is clear that inflation is not a serious concern over the medium term. And if activity levels do not pick up over the next few months, the Reserve Bank will once again cut rates in a bid to support and stimulate the economy.