SABRA LANE, PRESENTER: The Reserve Bank of Australia cut official interest rates today to a historic low of 1.5 per cent.

Mortgage holders are likely to be the big winners. If the cut's passed on in full, it will save roughly $700 a year on the cost of repaying a $300,000 variable home loan - but early indications are the banks won't pass it all on.

In slashing the official interest rate, the RBA is desperately trying to lift the inflation rate and growth.

To discuss the reasons for it and what's next if it fails, I was joined earlier by Andrew Charlton in our Canberra studio. Dr Charlton runs the economic consultancy AlphaBeta. He is also a former advisor to prime minister Kevin Rudd.

Andrew Charlton, thanks for talking to 7.30. Will the cut have much of an impact? Who will benefit the most from it?

ANDREW CHARLTON, DR, DIRECTOR, ALPHABETA: Well, interest rates benefit the economy in three ways: consumers benefit from higher house prices and lower mortgage expense; businesses benefit from cheaper borrowing costs and cheaper costs of investment; and exporters benefit from a lower Australian dollar.

So the idea is that lower interest rates give these three groups a shot in the arm; and that flows through to the economy.

SABRA LANE: That also assumes that the banks pass on the cut in full to mortgage holders. Some won't. The Commonwealth Bank has already indicated that it's not going to pass on that cut in full to mortgage holders; but, by the same term, it's lifting the term deposit rate for savers. What do you make of that strategy?

ANDREW CHARLTON: Well, Australia has suffered a big decline in banking competition over the last six years. And whereas there used to be a lot of pressure on banks to pass through interest rate cuts directly to their customers, now in an environment of slightly less competition, they have one eye on the customer response but also one eye on the profitability.

So banks in Australia at the moment are facing a bit less pressure to pass through those interest rate cuts and also are keen to mop up some deposits from savers where they can.

SABRA LANE: Is it a sign that the economy is in real trouble?

ANDREW CHARLTON: Of course it is. The cash rate in Australia was just reduced to the lowest level since the Reserve Bank was established in the 1960s. And the reason why the Reserve Bank has taken this unprecedented measure is that we are in unprecedented time.

This is one of the most significant periods of low income growth in Australia's history. Our commodity prices have fallen by half. Wages growth are at one of the lowest levels since the wage price index began. Company profits are incredibly low. And inflation has hit a 33-year low.

So desperate measures call for desperate times and this is a desperate level of interest rates from the Central Bank.

SABRA LANE: Given what you've just outlined there: in theory, this cut is supposed to encourage consumers to spend more, businesses to invest more. It's supposed to help exports. But given that growth is at a 30-year low, given that home ownership is at a 60-year low, wage growth has flatlined: what happens if this doesn't have any impact?

ANDREW CHARLTON: Well, this is precisely the challenge that the RBA faces. Cutting interest rates is supposed to be like starting a car: you turn it over until it gets going.

But the RBA has had the key in the ignition now for two years and the Australian economy has failed to deliver substantial sustained growth. Businesses have pocketed the interest rate cut, but not lifted investment substantially.

Consumers have benefitted from lower interest rates on their mortgage, but they haven't received the sustained tailwind of high incomes growth. So the problem with lower interest rates in Australia at the moment is: it's not delivering sustained growth. It's delivering a shot in the arm.

SABRA LANE: The RBA said in its statement that financial institutions now are in a position to lend to worthwhile purposes. Can you unpack exactly what that means? Because surely it wouldn't want to fuel housing prices any further in Sydney or Melbourne, especially given that property prices in other cities aren't going well and in regional areas it's gone backwards?

ANDREW CHARLTON: That's right. Well, the RBA has really two tools: one is the interest rate lever and one is the jawbone lever. And this is an example of the central bank using the jawbone lever: trying to encourage the financial institutions to take advantage of low interest rates in a responsible way and to spread credit right across the economy, rather than focusing on housing - predominantly an unproductive asset, and potentially in the throes of a significant boom.

So this is a strong plea from the central bank to encourage lending beyond the housing sector and predominantly to the business sector.

SABRA LANE: The statement also says that a considerable supply of apartments will come on-stream in the years ahead. Is it hinting that a glut there might bring about a correction?

ANDREW CHARLTON: I think it's more than hinting that. One of the biggest risks in the housing market in Australia is the massive increase in supply of apartments, particularly in Sydney and Melbourne. And it's potentially a significant source of instability.

I mean, this is one of the problems of having record low interest rates. One of the side effects is that you have significant financial instability associated with unusually elevated asset prices. And that is precisely what is playing out in the cranes across the skylines of Sydney and Melbourne and in the apartment glut that is about to come online.

SABRA LANE: What if inflation doesn't pick up? The bank hasn't really got much more room to move here. And if Australia does experience an unforeseen economic shock: you know, we've had 25 years of good growth. That can't continue. What's next?

ANDREW CHARLTON: Well, that's exactly the problem. When Australia experiences a recession, typically that recession is cushioned by the Reserve Bank delivering on average about 300 basis points in additional monetary stimulus; and by the Government delivering fiscal stimulus.

Now, the problem today is that if Australia were to run into another recession, we simply don't have the policy firepower to deal with it. Monetary policy is reaching its outer limits. Our fiscal resources have been depleted.

So one of the consequences of having extremely low rates is that, should another recession hit Australia, we are unfortunately unprepared.

SABRA LANE: Australia is now a low-inflation country in a low-inflation world. Should we just get used to it? Should the bank abandon its 2 to 3 per cent inflation target?

ANDREW CHARLTON: Well, it's too early to say whether they should abandon the target. But what we do know is that the context of central banking around the world has fundamentally changed.

Inflation targets were introduced in the 1980s and early 1990s and at that time the vast majority of countries were battling high inflation. Two-thirds of all OECD countries had inflation above 7 per cent.

Today the macro-economic context is sharply different. Now, two-thirds of OECD countries have inflation below 1 per cent. So the fundamental challenge for central bankers has shifted. And policy frameworks are still grappling to catch up.

SABRA LANE: Andrew Charlton, thank you very much for your time.

ANDREW CHARLTON: Thank you.