Introduction

Higher central bank interest rates have been a major driver of recent market performance. Bond yields have been rising on expectations of a lift in rates (especially in the short-end of the yield curve) while equity markets have been more resilient than most expected to the increase in yields. Higher interest rates have led to some wobbles in shares but the more recent weakness in shares has been from geopolitical risks around Russia/Ukraine and is proving to be a short term stagflationary shock.

The RBA is getting close to raising interest rates. At its latest Board meeting, the RBA sounded more hawkish and seems to be setting the scene up for a rate hike in coming months. We expect the RBA to lift the cash rate to at least 1% in 2022 (from 0.1%) and then to 1.5% in 2023. We then expect a pause in hikes from lower inflation outcomes (as supply side disruptions get resolved) before the likelihood of rate cuts in 2024 from lower inflation and a slowing housing market and the eventual resumption of interest rate hikes from 2025 as inflation starts getting uncomfortably high again. We go through the details of these expectations in this Econosights.

Inflation and interest rate hikes

The steep increase in inflation over recent months (which we have written about here) has been a wake up call for central banks to start normalising policies soon as economies have bounced back stronger than initially forecast from the 2020 covid recession. With US core inflation running at 6.4% year on year, Europe 3.0% and Australia 2.6% (with Europe and Australia likely to go higher), the high inflation environment could become entrenched without some tightening to monetary policy.

There are four main drivers of high inflation in Australia: 1/ The strong rebound in GDP growth (and in particular consumer spending on goods) after the slowdown in 2020, driven by extreme fiscal policy measures and an easing in monetary conditions. Lack of spending on services (because of lockdowns) added further demand for goods; 2/ Global supply constraints from shipping and transport challenges (due to covid), manufacturing plant closures (from covid) alongside an unexpected boom in consumer demand; 3/ A boom in global commodity prices (especially in oil and gas) from higher demand and supply challenges which were made worse by the Ukraine war which has now spread to other commodities like wheat, soybeans and corn and 4/ the flooding in northern NSW which will lift some food prices.

There are some signs that supply backlogs are easing. Costs of air freight, container shipping, freight costs are all moderating from late 2021/early 2022 highs. Lower consumer goods demand as services demand recovers and a global re-opening (which means more transport) will help to ease supply pressures further in the next 6-12 months time which should lower inflation. Offsetting some of the recent improvement in supply pressures has been the big rise in commodity prices (which were already elevated) over the past month from the supply disruption related to the war in Ukraine. Our inflation indicator of pipeline supply pressures had been trending down before the Ukraine conflict started in late February but then spiked up as commodity prices increased. It is now starting to trend lower again.

Our expectations for the RBA

We expect higher inflation in Australia over 2022 as prices for food, electricity, gas, rents and services all rise. We see annual trimmed mean inflation reaching around 4% by mid-2022. Because of this elevated inflation backdrop, we see the RBA taking the cash rate to 1% by the end of 2022 and to 1.5% by mid-2023.

On our measure, the ratio of housing interest payments to income will rise to just over 5% with a cash rate of 1%, this is above the current rate of 4.4% but still lower than the pre-2018 average of 6%. So, housing interest costs will not rise to unsustainable levels.

From mid-2023 we think that inflation will move lower as global supply-side issues are resolved, (with the high possibility that there is a goods “overhang” from a ramp up in goods production as demand declines) and as prior RBA interest rate hikes in 2022/23 slow economic activity. In 2023 we also expect home prices to decline by around 5-10% nationally which means a negative wealth effect for households. In this environment, the sharemarket is also likely to underperform. This low inflation and negative consumer backdrop could result in the RBA cutting interest rates again in 2024.

But the pause in inflation is likely to be temporary. We think the next 5-10 years will see higher inflation in Australia and globally compared to the past decade. The main factors driving higher global inflation include: a peak in globabilisation (which means less global trade, less downward pressure on global goods prices and countries bringing back manufacturing capabilites domestically), higher dependency ratios (the ratio of the working age population to those under 14 and over 65) which tends to be inflationary and lower Chinese GDP growth which means less exported deflation). Higher wages growth in the near-term will also add to inflation momentum.

We see the RBA eventually lifting the cash rate to its “neutral rate” from 2025 as inflation starts becoming problematic.

The neutral interest rate

The neutral interest rate is a level of the cash rate when the economy is in equilibrium. At this point. domestic investment and domestic savings are equal and the labour market is at full employment. Factors that lower (raise) savings or increase (decrease) investment increase (decrease) the neutral interest rate. While central banks don’t exactly know where the precise neutral rate is, it can be estimated through economic models. When the actual level of interest rates is above (below) the neutral rate, monetary policy is tight (loose) and has a contractionary (stimulatory) impact on the economy. This is why central banks like knowing approximately where the neutral rate lies.

The neutral rate has been on a downtrend for the past 10-15 years, alongside potential GDP growth, interest rates and bond yields. The RBA estimates the neutral rate to be somewhere around 2.5 3.5%, from over 5% pre-2007. So, with the current cash rate at 0.1%, monetary policy is running very easy in Australia. We have been of the view that the neutral rate is lower at 2-2.5% because of high household debt to income levels. However, the risk is that the neutral rate will actually be higher over the next few years because savings will decline. Excess household savings over the pandemic (worth $235bn or 11% of GDP) will decline as consumer spending rises (this is already occuring in the US), household wealth is likely from lower asset prices (especially houses), a higher dependency ratio also means lower national savings and government deficits will be much larger compared to pre-Covid numbers which drains national savings. The outlook for business investment is also stronger than it has been for years and higher investment puts upward pressure on the neutral rate.

Conclusion

We think that the forthcoming interest rate hike cycle will occur in two stages. High inflation over 2022/23 will push interest rates to 1.5% over the next year before an easing in inflation from an improvement in supply-side issues will cause a pause in the hiking cycle with the chance of rate cuts in 2024. However, we think that inflation is headed for a period of being higher over the next 5-10 years and the RBA will eventually start to increase interest rates towards “neutral” in 2025.

Financial markets are pricing in a straight line of interest rate hikes in Australia to 3.5% by mid-2024. Rate cuts are then expected in 2025, as the market anticipates that central bank rate hikes choke economic activity. We think that markets are overestimating near-term inflation but are underestimating the longer-term inflation backdrop. The overall takeaway is that interest rates are going higher, but not likely to be high enough in Australia to choke off economic growth or cause a recession. So, on a 6-12 month view,we think that sharemarket performance can still be solid and positive. Bond yields are probably unlikely to go higher in the short end but our higher longer-term inflation backdrop means that long-end yields still have room to rise.