Shrugging off slow first quarter growth in the US economy, the Federal Reserve increased its policy interest rate earlier this month, and intends to do more. Not long after, minutes of a meeting of the Bank of England’s Monetary Policy Committee surprised markets by revealing that three of its eight members now look to increasing the UK policy rate – despite political turbulence, uncertainty over Brexit, modest output growth and low inflation. Around the same time, a Deputy Governor of the Bank of Canada, Carolyn Wilkins, hinted at a tightening there much sooner than the market was expecting. Last week the Reserve Bank of New Zealand left its policy rate unchanged, but markets look for the next move to be up.
Where does this leave the Reserve Bank of Australia? My guess is that it is already thinking about a program of rate increases that will continue for several years.
As the RBA has been arguing for some months, global growth is picking up. Output in the US, the Euro area and the UK all grew by 2% in the year to the March quarter. China’s output expanded by 6.9% over the same period, and East Asia generally was firmer. Output in Japan increased 1.3% - pretty good for an economy in which the workforce is actually shrinking. These outcomes are certainly not hectic but they are more consistent across the global economy than we have seen in most of the years since the 2008 financial crisis.
While output growth has been strengthening, so too has international trade and global industrial production, important indicators discussed at the RBA board meeting earlier this month. And while headline inflation around the world has been dented by the renewed fall in oil prices, the RBA discerns (and welcomes) upward pressure on underlying inflation in major economies.
Thus the growing trend to higher interest rates, which in most advanced economies are still unprecedentedly low. As the impact of the 2008 crisis fades, so does the rationale for super low central bank policy rates.
Earlier this month the RBA left unchanged its 1.5% policy rate – the lowest ever.
In principle the RBA does not need to be bothered by what other central banks do. After all, Australia’s floating exchange rate is said to give the RBA the independence to make interest rate decisions appropriate for Australia, without regard for other central banks. It has an inflation target to guide its policy, and right now inflation is well under target.
Mind the gap
In a world of rising interest rates, however, those are not the only considerations around the RBA board table. The Bank will also be bothered if there is a widening gap between its policy rate, and Australian market rates.
So far, that is not evident for short term loans or standard owner occupied housing loans. Rates on investment lending for housing have sharply increased, but that suits the RBA and has been encouraged by the Prudential Regulation Authority (APRA).
Influenced by the global rise in yields, the interest rate on 10-year Australian government bonds has increased 66 basis points since August of last year, the month the RBA took the overnight rate down to 1.5%. Even so, the spread between the bond yield and the policy rate is now only a little higher than average over the last 20 years.
At the same time the gap between US and Australian market rates has been narrowing. Australian government yields are usually well over US government yields. That spread is now down to around 30 basis points, about one fifth of the average spread over the last 20 years.
That ought to mean that the exchange rate of the Australian dollar against the US dollar should be falling, but it isn’t. Somewhat higher commodity prices over the last year or so have perhaps counteracted the diminishing spread to US interest rates. Since the recent low of US70¢ a couple of years ago, the Australian dollar has come back up to trade recently a little over US76¢. The Australia dollar has recently weakened against a stronger Euro, and against the trade weighted measure of the exchange rate, but the main point is that the Australian dollar has been remarkably resilient against the narrowing spread to the US – at least up to now.
The RBA does not care for this resilience. It remarked this month, as it usually does in its published minute of board discussion, that a higher exchange rate would be unhelpful in achieving the bank’s forecasts of rising inflation and output growth.
So neither the gap in Australia between market rates and the policy rates nor the spread between Australian and US bond yields is signalling that the RBA will soon need to increase its cash rate. Nor is the Australian dollar – on the contrary, it is stronger than the RBA would prefer to see. And while the RBA thinks consumer price inflation will rise, it is still below the 2% to 3% target band.
So why would the RBA even be thinking of following other central banks in tightening rates?
The time is coming to get back to normal
The answer is that the RBA is well aware the policy interest rate, the overnight bank rate it manipulates, is way below where it will need to be in the years to come.
Over the last 20 years the average policy rate has been 5.2%, more than three times higher than the current rate. Even during the aftermath of the 2008 global financial crisis the lowest the Bank took the policy rate in its emergency response was 3%, twice the current rate.
At 1.5% it is, after all, less than a third of the rate not so long ago considered to be around the bottom of the range for a ‘natural rate’, one that would be consistent with the economy growing around potential and with inflation within the 2% to 3% target.
It is certainly possible that the ‘natural’ or equilibrium rate may in the future prove to be markedly lower than in the past. We may have got used to a new and lower structure of rates. It is possible that expected returns on business investment have fallen, and consequently low funding costs will be required to undertake investment. Household mortgage debt is high, and in Australia most mortgages have variable interest closely related to the RBA’s policy rate. The bigger the household debt, the more impact a quarter percentage point increase in the policy rate will have on household spending. In the Australian case it is certainly possible that high household home mortgage debt will crimp consumer spending if the policy rate returned to what was once considered a relatively low long term rate.
Even so, even if the RBA now thinks a long term rate may in the future be, say, 3.5%, it is still quite a way from today’s rate.
For the RBA the issue then is the path to get there. It will not move too abruptly or unexpectedly.
If inflation does indeed return to 2.5%, as the Bank now expects, if growth does indeed return to 3% ‘within a few years’, as the minutes of the June board meeting predict, if the world economy is indeed picking up, then a policy rate of 1.5% is too low.
Let’s say for argument the RBA wants to start next year and get to 3.5% in two years, which is surely within the range of outcomes it would think about. If each increase is 25 basis points, it needs to make eight of them, or say four a year. This implies that within three years Australia’s economic world has returned to more-or-less normal, with wages growth of 3.5%, inflation of 2.5%, and output growth of 3%. But this is, after all, exactly the forecast that both the Bank and the Australian Treasury publicly offer.
It seems to me that something like eight quarter percentage point tightenings over 2018 and 2019 are distinctly possible, if the RBA’s economic forecasts prove correct. It's possible the tightening could start earlier, or if not the tightening itself, at least the signalling which should precede it. We may be seeing a little of that now.
The RBA would not want to find itself with a 2% or 2.5% policy rate if the Australian economy is operating at around its potential of 3% growth and with inflation of 2.5%.
Because it makes small steps, does not usually commit itself to making subsequent steps, and does not itself make forecasts of its own policy rate, the market is usually shy of predicting where the Bank will be in a few years. It seems to me, however, that in this particular set of circumstances we can reasonably assume that (1) the RBA considers its current rate to be exceptionally low (2) if the economy improves as it predicts the next move will be up and (3) that if the economy was operating, as the RBA predicts, at 3% output growth and 2.5% inflation, it would think of a sustainable or natural policy rate as at least 3.5% and, most importantly, (4) it will want the policy rate increase to match the forecast improvement in Australia’s economy performance, so it will want to be at 3.5% (at least) by the end of 2019.
Like loosening episodes, tightening episodes appear to accumulate tactically but are in retrospect strategic. Nor are they necessarily gentle, or gradual. As governor, Ian Macfarlane took the rate from 4.75% in October 1999 to 6.25% in August the following year. Macfarlane and then his successor as Governor, Glenn Stevens, took only two years to move from 5.5% in April 2006 to 7.25%. Stevens later took just over a year to go from 3% in August 2009 to 4.75%.
If this kind of trajectory is realised, the big thing markets and households will be discussing over the next two or three years is when the next rate rise will be announced, and when the sequence of tightenings will end. Now around 5.3%, the standard variable rate on home mortgages will be around 7% or a little more. Today’s secured small business overdraft rate of 7.3% will be closer to 10%. Influenced by a continuing rise in US yields, the 10-year Australian government bond, which now yields 2.6%, may yield 3.5% or 4%.
Prime Minister Malcolm Turnbull would probably not be overjoyed by a prolonged RBA tightening episode coinciding with the period through which he hopes to shape an election strategy, but the increases will cause less distress than will be widely observed. Despite the big rise in household mortgage debt, for example, it is still the case today that the total of interest paid today on Australian household mortgages is very much less than it was six years ago, because while debt has increased a bit, interest rates on the total of outstanding debt have fallen a lot. As a share of household disposable income, housing interest payments are now 7% compared to 9.5% in 2011, or 11% at the peak of the RBA tightening episode before the 2008 financial crisis. If the standard variable mortgage rate peaked out at around 7% that would still be nearly one percentage point below the 2011 level, and two and half percentage points below the 2008 peak.
The pace of tightening will anyway be governed by the strength of the economy. If household spending weak
nessens, if the long expected firming of non-mining business investment is further delayed, if the Australian dollar strengthens, if employment growth is persistently weak, then the trajectory of rate rises will be less steep and the pace less rapid.*