An hour into the media conference following Tuesday’s increase in the cash rate to 0.35%, the Reserve Bank Governor Philip Lowe delivered a mea culpa. He said there would be an internal review later in the year of how the Reserve Bank provides forward guidance, that is, its predictions about the future course of interest rates.
To use Lowe’s own words, he “should have done better” in his attempt to make a prediction about rates two to three years ahead when circumstances are still unpredictable and changing quickly. He was, of course, expecting inflation to moderate by the middle of 2022.
“Cast forward six months, what’s likely to happen? I suspect we won’t be buying as many electronics, we’ll be going to cafes and travelling and the supply side problems in the chip market are now being resolved and the price of chips are coming down. I suspect on that category we’ll go back to more normal rates of increase. The same with cars.”
Philip Lowe Press Club, 2 February 2022
Now, the forecast for 2022 headline inflation is 6% and underlying inflation of around 4.75% versus the Reserve Bank range of 2% to 3%. In Lowe’s defence, on 2 February, there were no lockdowns in China or war on Ukraine. Both events have been significant contributors to inflation.
The markets have, of course, been factoring substantial rate rises in for some time, but for some reason, it is a message that Lowe has not been up for.
“We keep looking at the markets and trying to understand what they’re telling us, but I still struggle with how the same interest rate reaction is priced in for Australia and the US.”
The main lesson from all this, as Philip Lowe admits, is not to hang on his every word each month. Interest rate guidance is based on forecasts which can be wrong.
In fact, there is a good chance that central banks will be forced to reduce interest rates within a year or two to stimulate a slowing economy. There is now considerable speculation about the so-called ‘neutral’ cash rate, the point which neither stimulates nor contracts the economy. According to a press release from KPMG
“Quite recently the cash rate in Australia was considered to be at a neutral level – neither expansionary nor contracting, the ‘goldilocks’ official rate – when it was sitting at around 3 percent. Some economists are now suggesting, that given the level of debt being carried across households, this neutral rate is now somewhere around mid-1 percent.
It is difficult to accurately say the precise level of a non-stimulatory/non-contracting official interest rate – however KPMG considers it is most likely to be lower than historical levels, and probably closer to 2 percent to 2.5 percent .
Which is well under current market rate expectations.
What does it mean for the economy?
- While rate hikes will cause bouts of uncertainty and see economic growth slow (experts predict around a 2.5% drop next year from 4.5% this year), it is unlikely that the rate hikes this year will be enough to end the economic recovery and trigger a recession.
- Historically, Australians have been able to tighten their belts and make extra payments when rates have risen. It has only been when unemployment reaches high levels that there has been real mortgage stress. In our view the still strong jobs market will continue to support households and as the 2020 experience showed, governments and their central banks are now willing to do everything possible to support jobs and income.
- The household sector as a whole is estimated to be sitting on around $250bn in excess savings, built up through the pandemic (there is room).
- Don’t forget that since the mid-1990s, there have been four rate tightening cycles (1994, 1999-2000, 2002-2008 and 2009-2010), none of which caused a recession.
What does it mean for markets?
- In the short-medium term, rising rates from a low base are normally not bad for shares, as they are seen to be off the back of improving economic conditions.
- Unless rates reach onerous levels, contributing to an economic downturn, e.g. such as 1981-early 1982, late 1989 and in late 2007 to early 2008, then rising interest rates aren’t necessarily viewed as a problem.
- If the RBA cash rate rises to 1.5% by year end – remembering that rates were last at 1.5% in 2019 when the economy was bubbling along nicely – deposit rates will still be below 2%. This is still low relative to the gross dividend yield on shares (around 5.5%), leaving shares relatively attractive.
- Given the correlation between Australian shares and US shares, arguably, what the Fed does is far more important than local interest rates, and this is perhaps a bigger risk given higher inflation in the US.
- An environment of rate hikes will likely result in a continuous period of volatility. Investors should expect choppy waters for some time.