The Reserve Bank likes playing limbo, and maintains some flexibility to do so.
The Reserve Bank likes playing limbo, and maintains some flexibility to do so.

How low can interest rates go?

I'VE never been any good at doing the limbo.

Partly because of my lack of flexibility, partly because of my lack of balance, and partly because I can't help but break into dance every time someone turns on Chubby Checker's catchy tune, Limbo Rock.

The Reserve Bank of Australia, on the other hand, is great at the limbo when it comes to interest rates.

In the past eight years it has dropped its official cash rate 12 times, by a total of 3.25 percentage points, to its current low of 1.5 per cent.

And now that it has backtracked on its warnings that rates will go higher, prompting several economists to predict rate cuts later this year, the big question is clear.

How low can the Reserve Bank go?

Do I hear 1 per cent? Do I hear 0.5 per cent or zero per cent? And what the heck does it all mean anyway?

Kids are great at the limbo, but the Reserve Bank of Australia is even better.
Kids are great at the limbo, but the Reserve Bank of Australia is even better.

A lower interest rate means that borrowers pay less on their mortgages, savers get less from their bank deposits, and the Aussie dollar probably drops in value - bad for travellers heading overseas but good for exporters.

The RBA cash rate works like a handbrake or accelerator on the economy. Raising the cash rate slows things down because it costs more to borrow money, while cutting the rate should be a shot in the arm to boost consumer spending, inflation and economic activity.

But the dozen rate cuts since November 2011 haven't caused our economy to go gangbusters, and there's no guarantee more cuts will do the same.

The RBA's cash rate movements drive the direction of short-term interest rates and variable home loan rates.

So if the RBA makes two more 0.25 percentage point cuts to 1 per cent in the next 12 months, borrowers should expect to pay roughly 0.5 per cent less on their loans.

However, lenders aren't shy about putting up their rates even when the RBA isn't, and many have done this in recent months.

If the RBA really gets into the limbo spirit, and our economy warrants it, it can potentially cut the cash rate to zero. This would result in many mortgage interest rates around 3 per cent.

Beyond zero, it could follow the lead of the US during the Global Financial Crisis and start printing money in a practice known as quantitative easing.

This strategy worked well for the Americans because the US dollar is viewed as the world's reserve currency, but not so well in countries such as Zimbabwe, which went broke and suffered hyperinflation.

Nobody knows what would happen in Australia, and nobody is predicting that our official interest rate will go to zero in the current economic climate.

However, the RBA said late last year that more rate cuts and quantitative easing were tools that could be used if needed.

Whatever your interest in rates - whether as a borrower, saver, investor or first homebuyer - it pays to keep in mind that the RBA's limbo stick looks increasingly likely to be lowered.