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Markets are convinced the Reserve Bank is almost finished raising interest rates, if it’s not already there, and by this time next year traders are betting on a rate cut.
Will those traders be right? The honest answer is, who knows? The past few years have shown that forecasting interest rates with any precision can be a mug’s game.
Illustration by Jozsef BenkeCredit:
But despite those risks, here’s a more confident prediction. When interest rates do fall – and they will at some stage – they’re highly unlikely to fall by anything like the 3.5 percentage points in rate rises we’ve had over the past year.
Why? Because with the benefit of hindsight, it’s now pretty clear that in their moves to shield the world economy from the coronavirus threat, by taking interest rates to zero and launching “unconventional” stimulus policies, the central bankers overdid it.
To be sure, slashing interest rates and undertaking experimental monetary policies seemed like the right thing to do at the time.
But a few years down the track, we now know things went a bit far. Not only did the low-rates era arguably made our current inflation problems worse, it also left the financial system more vulnerable to bouts of instability.
It’s now pretty clear that in their moves to shield the world economy from the coronavirus threat, by taking interest rates to zero and launching ‘unconventional’ stimulus policies, the central bankers overdid it.
Given all the scrutiny they’re now under – including this week’s critical RBA review – the central banks will be dead keen to avoid making the same mistakes again.
It’s hard to think of an economic topic that gets more attention in Australia than interest rates. Most of the time, it’s a one-sided story. Lower rates are generally presented as a good thing.
However, a speech from the general manager of Switzerland-based Bank for International Settlements, Agustin Carstens, highlighted how years of using interest rates as the main tool for dealing with economic problems is taking its toll.
Carstens, who was speaking about central banks globally, made a convincing case that many big economic challenges in the world today – high inflation and the risk of financial businesses getting into strife – are at least partly the result of the prolonged period of ultra-low rates.
The RBA has admitted its response to the COVD-19 pandemic went too far.Credit: Peter Rae
In the jargon, changing interest rates is referred to as monetary policy. For the past three decades or so, it’s been the main way in which developed countries have managed the ups and downs of the economic cycle. The other main arm of economic policy is fiscal policy – government taxing and spending.
Monetary policy is carried out by independent central banks such as the RBA, which try to keep inflation in a target range by raising or cutting interest rates. (Incidentally, this week’s review of the RBA does not call for major changes in inflation targeting, but rather for different faces around the RBA table that makes the decision).
Whenever there’s been an economic downturn or crisis, the central bankers have been on the front line of the response, ready to cut interest rates. So sure enough, when COVID-19 struck, it was met with an almighty barrage of action from central banks, alongside unprecedented fiscal stimulus.
To be fair to the central bankers, they were staring down the barrel of economic Armageddon.
Reserve Bank deputy governor Michele Bullock explained last week just how dire things were looking at the time, saying the RBA was worried about “the potential for people to lose their jobs and never get them back again”.
“This was unprecedented, and I think people forget that we had shots of morgues in the streets in New York and Italy and, it was shocking stuff,” Bullock said.
But Bullock also acknowledged their response went a bit too far.
Carstens points out that by 2021, the response from central banks meant interest rates were effectively at zero, while central bank balance sheets and public debt were at record highs.
This extraordinary combination of ultra-cheap money and heavy government stimulus was hugely stimulatory, and we now know it made the surge in inflation more powerful than it would have been otherwise.
Prices initially surged for other reasons: COVID-19 disruptions to supply chains; soaring oil prices caused by Russia’s invasion of Ukraine; and a sharp rebound in consumer spending from lockdowns. But the huge amount of stimulus from fiscal and monetary policy meant those price rises have undoubtedly been sharper.
Alongside inflation, it’s also hard to ignore how the policies of ultra-low rates have fed into recent financial instability – such as the collapse of US Silicon Valley Bank. While this bank had its own specific failings, it suffered a run because its depositors were spooked by sharp falls in its large holdings of most government debt, which it had invested in at a time of ultra-low rates.
Reflecting on the lessons of the past few years, central bankers may well be more cautious in how aggressively they cut rates in response to the next downturn.
But how the central bankers respond to crises is only part of the story. According to economic theory, interest rates are also a function of inflation. Rates will be higher in times of high inflation as the RBA applies “contractionary” policy (as it’s doing now), and lower when inflation is low.
And guess what? Some economists think the world we’re in today is more inflation-prone than the one we had before the pandemic.
In the three decades or so to 2020, various deep-seated changes in the global economy all helped to keep prices low: globalisation unleashed more low-cost manufacturing overseas, while technological change sparked new forms of online competition.
But these forces are no longer depressing prices like they once did. Some argue we’re in an era of “deglobalisation” as more companies bring manufacturing closer to home markets, for example.
The RBA’s also previously argued that an ageing in the world’s working age population, climate change, and decarbonisation could also make inflation more volatile than it’s been in the past.
All of that suggests that even when this bout of inflation passes, interest rates are unlikely to settle back at the 1 per cent level they were at before the pandemic, unless there’s a major recession on the cards.
Near-zero interest rates seemed like a good thing for those of us with debts, and raising them inflicts a lot of pain. But the longer-term costs of cheap money have also become all too apparent.
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