Where Will Interest Rates Go Next?

Two years ago, almost to the day, the Reserve Bank of Australia (RBA) began hiking interest rates to tame “transitory” inflation pressures. The central bank has since increased the cash rate on 13 separate occasions, from 0.10% to currently rest 4.35%.

Since the RBA last increased rates in November, the consensus view has been that the central bank had sufficiently tightened monetary policy to bring inflation under control. This has, at least in part, spurred the recent strength in asset prices as investors begin to price in the possibility of rate cuts in 2024.  

That was until the most recent inflation numbers came in ahead of expectations. Traders have now erased all possibility of rate cuts this year, with some economists even calling for rate rises to quell rising prices.

We have never been in the game of forecasting, and we won’t enter the arena today. Instead, we outline what will determine the direction of interest rate policy in the weeks and months ahead.

Rise Up  

The case for raising interest rates is predicated on inflation failing to subside. On face value, the March CPI print of 3.6% confirms inflation is falling and approaching the RBA’s target band of 2-3%. However, the central bank’s preferred measure trimmed mean (which removes volatile inputs such as energy prices) is still at 4.0%.

Source: RBA

Moreover, several categories that make up the basket remain well beyond what the central bank would consider sustainable including:

• Insurance (+16.4%)

• Postal Services (+15.4%)

• Hairdressers (+7.1%)

• Rent (+7.8%)

• Bread and cereal products (+7.2%)

Anyone who has tried to contact a tradie recently will attest capacity constraints remain, particularly regarding labour. This is evidenced by near-record low unemployment of 3.9% in addition to low levels of underemployment.

On the demand side, record immigration is straining an already tight housing market. Next quarter’s stage three tax cuts will increase disposable income and businesses have yet to scale capital expenditure despite tougher economic. Should these factors culminate in a reacceleration of prices, the RBA will be forced to raise rates to reinforce its inflation-fighting credibility.

Hold the Horses

Despite the most recent CPI exceeding expectations, inflation is still trending in the right direction and in line with the central bank’s forecasts. The print may lead to a marginal shift in rhetoric from the RBA, but it’s unlikely the central bank would react immediately to one print. 

The argument that interest rates are higher in places such as the UK and the US, so Australia go higher does not necessarily hold water. We know that Australians are relatively responsive to changes in interest rates owing to a population of borrowers with primarily variable rates loans.

Household debt levels and the proportion of income spent on mortgage repayments also remain high compared to international peers. Moreover, for over two years, real incomes have gone backwards as wage rises have failed to outpace inflation. Households are certainly doing it tough, mitigating against the possibility of an inflation spike.

Source: The Australia Institute

Time to Cut

The case for lowering rates boils down to economic growth. In the latest ABS figures, the economy rose only 0.2% for the quarter and 1.4% for the year. However, once we account for 518,000 new migrants domestic output shrunk by 1.5% on a per capita basis. In other words, the economy is going backwards without the extra output of new entrants.  

Consumption remains tepid, evident by the soft retail figures and sentiment remains at recession-like levels. Expectations for family finances, economic conditions and employment are all down compared to one and two years ago. Should the economy fall into a recession, that would likely lead to the RBA to ease monetary policy and consider rate cuts. 

Header Image: CNBC