A few more thoughts on interest rates…and why they’ll likely stay flat for a while- Pete Wargent

Inflation in the pipeline?

Now that the dust has settled after the recent interest rate decision, markets and commentators  had a little more time to digest the news.

As a quick re-cap, the good news is that the Reserve Bank has upgraded its growth forecasts and broadly expects to see the economy growing at around 4% pace again through 2016/17, although it must be said that sceptical commentators have identified a number of downside risks to that outlook.

On the flip side, the most recent inflation figures showed trimmed mean and weighted median readings sneaking all the way up to 0.9% for the quarter and 2.6% for the past year.

What’s the worry?

The risk here is that with a cash rate of 2.50% then the real rate of interest (i.e the interest rate adjusted for inflation) may be too low. This might eventually lead to an overshoot in GDP growth and higher inflation.

Further, if the bank holds the cash rate where it is while, inflation rises, then the real rate of interest falls even lower and then the inflation genie is well and truly out of the bottle, it’s hard to get him back in.

The big question on most people’s lips is at what point will the Reserve Bank need to move the cash rate back up towards a more neutral setting in order to prevent this happening.

 

Why the interest rate is key

The interest rate is the key tool in controlling inflation today, but it was not always thus.

Once upon a time, there was spirited debate about whether the choice of monetary instrument should be the rate of interest (R) or the money supply (M). I blogged a little about the history of monetarism here.

The problem with the controlling the money supply approach – quite apart from the fact that there are so many different ways of measuring ‘M’ – is that in recent decades the statistical relationship between the money supply and the growth of the economy fell to pieces.[sam id=40 codes=’true’]

Perhaps even beyond that, the basic questions of how one should measure ‘M’ and how fast it should grow never really got any satisfactory answers.

The interest rate tool won by default, as the former Bank of Canada Governor Boey put it: “We did not abandon the monetary aggregates. They abandoned us.”

It was not until 1993 when Federal Reserve Chairman Alan Greenspan formally announced that the Fed would be applying “less weight” to the monetary aggregates going forward.

This giant understatement caused some mild amusement in the markets, for the simple fact that the Fed had been applying zero importance to the monetary aggregates for many years and everyone knew it.
What of the banks?

And what of the banks creating money through loans? For my money, in a leveraged economy such as Australia, it all comes back to lending standards.

If lending standards decline, then the wheels can really come off.

Historically it’s been said that our lending standards have been relatively high in Australia, but remember, we haven’t high high unemployment for a long time, and that combined with robust house price growth can comfortably mask a proliferation lower quality loans.

And I note that lending standards appear (to me at least) to be easing. Low doc loans are quite readily available for those with a 20% deposit, while TV adverts are starting to appear offering higher LVR loans. APRA needs to watch this very carefully.

 

And finally, what next for interest rates?

The one thing which stood out as confusing in the most recent Statement on Monetary Policy was that while the economic outlook showed stronger GDP growth returning, it also showed inflation forecasts falling.

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A bit odd on the face of it? If these inflation forecasts are correct, then the cash rate will not be raised for months, possibly for more than a year.

One answer is that the labour market might be too soft to cause higher inflation as the mining construction boom unwinds, while wages growth has been subdued of late, therefore inflation will stay in the target 2-3% range for some time to come.

This was the basic premise of the ‘Phillips Curve‘: if unemployment ticks higher the decreased spending power of consumers eventually must eventually bring inflation lower.

It seems to be the case that nobody, including the Reserve Bank, is quite sure what has caused the recent jump in inflation – it could be the fall in the exchange rate – and whether it is permanent or something that can be ‘looked through’.

It’s often alleged that Central Banks take more heat for raising interest rates than they do for cutting them.

Whether or not there is any truth in that, it seems unlikely that there will be any upward movement in interest rates until another round of inflation data has been released, and the next print isn’t due until April 23.

So, the RBA is in wait-and-see mode. And, on that very point, we have some very important data to be released in the next couple of days, including housing finance, house price indices and the all-important Labour Force data on Thursday.

[post_ender]



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Pete Wargent

About

Pete Wargent is a Chartered Accountant, Chartered Secretary and has a Financial Planning Diploma. He’s achieved financial freedom at the age of 33 - as detailed in his book ‘Get a Financial Grip – A Simple Plan for Financial Freedom’. Pete now manages his investment portfolio, travels and works as a consultant in the finance industry from time to time. Visit his blog


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