iPartners inFocus - Interest rates: are we there yet?

• Central banks are still lifting interest rates and signalling more to come.
• But the size of rate moves has stepped down.
• Central banks note inflation is slowing and there is a need to assess the impact of rate rises thus far.
• The implication is that peak rates are near – financial markets are pricing rate cuts for late 2023. 
• A “soft landing” is likely.  But it may feel like “recession” in some economies (especially Europe) and some sectors (especially housing).

It’s a new year.  But global central banks have kicked things off in much the same way as they finished 2022: with a series of rate rises (Table 1).

Major central banks like the Fed, the European Central Bank, the Bank of England, the Bank of Canada and the Reserve Bank of Australia have all lifted policy rates by 25-50bpts so far in 2023. Other central banks in Indonesia, Israel, South Africa and South Korea have joined the party.

Central banks are responding to the inflation genie.  Now out, it is proving difficult to stuff that genie back into the bottle:

• the US inflation rate lifted from 1.4% at the end of 2020 to a peak of 9.1% in 2022 (the highest since 1981); and
• on the same basis, consumer price inflation in the rest of the world lifted from 1.2% to a peak of 7.3% (the fastest pace since 1996). 

The main policy weapon is interest rates.  The main policy risk is recession.  As RBA Governor Lowe succinctly put it: “the path to achieving the needed decline in inflation and achieving a soft landing for the economy remains a narrow one”.

Central banks need to be convinced they are winning the inflation fight before they will rule out further rate rises.

And there are some encouraging signs. Inflation rates may be running above their pre-Covid averages (Chart 1). But the peak does appear to have passed (Chart 2 – countries are gravitating into the disinflation quadrant). And the degree of inflation “surprise” has eased back (Chart 3).

Some central banks are beginning to discuss an easing in the pace of policy tightening.  The implicit aim is a return to “normal” 25bpt moves rather than the 50-75bpt increases that predominated in 2022.  Some, like the Fed, the RBA and the BoC, have already made this quantum shift.

Central banks are paid to worry.  The pace of tightening may ease back.  But nearly all are talking about further rate rises.  The RBA, again, captures the tone: “the Board expects that further increases in interest rates will be needed over the months ahead”.    

The uncertainty about peak interest rates, and the duration of those peak settings, will keep recession fears alive.  Markets are putting a high probability on recession as a result.  US bond market pricing, for example, implies a 47% chance of a US recession in 2023 (Chart 4).  But other recession indicators, such as those derived from US labour markets, imply no recession and a soft landing (Chart 5). 

This dichotomy is reflected in forecasts made by the major international agencies such as the OECD and IMF.  All are quick to talk up recession risks.  But all are projecting soft landings.

Picking the peak

Economists have developed a range of techniques for determining terminal policy rates.  Contrary to popular belief these techniques do not include tossing coins or polishing crystal balls. They do include:

i. Reading the tea leaves

Every word uttered by central bankers is scrutinised for some hint of what comes next.  At the extreme, this scrutiny includes applying machine learning techniques to try and predict policy moves based on the language of official communications.  RBA use of the word “strong”, for example, tends to accelerate before rate rises (Chart 6).

Central bankers are aware of this scrutiny and attempt to use it to their advantage by providing “forward guidance”.  The belief is that this guidance will reinforce the impact of policy changes.

For RBA watchers, as noted earlier, the current guidance involves signalling more rate rises (plural).  But they also acknowledge the risks of going too far.  And the need to allow the rate rises already in place to work through the economy.   

The message is that the peak is near.  The use of “rises” suggests at least two.

A word of caution on guidance: it is not always reliable!  Not so long ago RBA Governor Lowe was assuring all and sundry that rate rises were unlikely.  And that (earlier) low rates would persist through to 2024.

ii. The message in the star(s)

Central banks will always stress that initial moves on the rates front are not policy tightening.  Rather it is about removing some of the policy stimulus.  But, once underway, the objective is usually about getting back to some neutral level of rates.  Economists have designated that neutral rate as r-star (r*). 

For RBA watchers, current estimates put neutral in a 3-4½% range (Chart 7).  This range is wide enough to drive a truck through.  The standard approach is to take the midpoint (of 3¾%). 

The message is that two more 25bpt rate rises would get monetary policy settings back to neutral.

iii. Leave it to the market

The policy interest rate is a key driver of the overall structure of interest rates.  So financial markets are very interested in where the terminal interest rate lies.  

The idea is that financial markets are efficient and process a significant amount of information in determining market pricing.  The shorter end of the yield curve reflects current and expected monetary policy settings.  These settings are an important driver of near-term economic activity.  The longer end of the curve summarises expectations of future inflation and real interest rates.  And so are an indicator of where the market believes the economy is heading from a longer-term perspective.

The overnight indexed swap (OIS) market gives a pure read on where markets think policy rates are going.

For RBA watchers, the Australian market has priced-in a peak cash rate of 3¾% (Chart 8).

The message is that the short end of Australian rates markets believes the RBA has two more 25bpt rate rises in its policy armoury.

Longer-term bond markets also have a view on where the cash rate will end up.  A 10-year bond can be thought of as a series of daily interest rates (the RBA’s cash rate) plus a term premium for the risk of locking up your funds for ten years.  Rearranging the equation reveals the market pricing for the terminal cash rate (10-year bond yield less the term premium). 

For RBA watchers, Australian bond markets have an implied terminal cash rate for the current cycle at around 3¼% (Chart 9).

The message is that we are already at the peak!

Table 2 summarises the range of estimates.  The average of those estimates implies two more 25bpt cash rate rises.  And a terminal rate of around 3¾%.

Timing the top

The current monetary policy cycle is notable for its aggression.  Central banks pushed through unusually large rate rises in rapid succession. 

The Fed, for example, lifted the fed funds rate by 450bpts over eleven months.  The RBA was not far behind, managing 325bpts of rate rises in ten months (Chart 10). 

The implication is that central banks are in a hurry to get to their terminal rates. 

Financial markets can help again with the timing.  Market pricing has the terminal rate being achieved by:

• May 2023 for the Fed;
• July 2023 for the BoE; and
• October 2023 for the ECB.

For RBA watchers, market pricing has the peak cash rate in place by August 2023.  The likelihood is the RBA gets there sooner – probably April.

All of the focus is on the peak cash rate and when that peak will be in place.  But market pricing also reveals an expectation that rate cuts are possible late in 2023 (Chart 11).

On that point, history shows that the time spent at the interest-rate peak is relatively short.  The average time the Fed, for example, held the peak level of interest rates over the past 4 policy cycles was 9 months.

For RBA watchers, the average time at peak rates over the last 4 policy cycles was 11 months (Chart 12).

These considerations are important because, in the end, it is the level of interest rates that does the work on the economy. 

Gauging the impact

It is true that the monetary policy tightening cycles of the past couple of decades have been followed by slowdowns or recessions (Chart 13).  And it is true that central banks are often portrayed as holding the smoking gun.  But recessions always have other contributing factors.

The global recession of 2008-09 was one outcome of the global financial crisis.  The global recession in 2020 was an inescapable response to the pandemic and associated lockdowns. 

And higher interest rates were only one of the reasons that global and Australian GDP growth forecasts were downgraded during 2022. 

The Russian invasion of Ukraine generated a geopolitical shock that quickly morphed into an energy price shock.  And a food price shock.  Higher energy and food prices contributed to an inflation shock more broadly.  Households are dealing with the resultant cost-of-living shock. 

This combination of drivers could produce a recession in 2023.  But the major forecasting agencies, as noted earlier, are not forecasting a recession.  The IMF, in January, revised up its global growth forecast for 2023 to 2.9%. 

Growth at that pace would be below the 2000-2019 average of 3.8%.  But it is a long way from recession. 

Averages conceal the wide range of outcomes across countries.  It may not be a global recession.  But it will feel like it is some advanced economies – especially in Europe and Latin America.

In Australia, one of the key questions for 2023 is what impact a 3¾% cash rate will have on the economy?

The RBA has constructed a useful “road map” on how changes in monetary policy impact on the Australian economy (Diagram 1). 

The main transmission channels identified by the RBA are:

• Savings & Investment: changing interest rates impacts on the incentives to save and invest, with a flow on to consumer spending, housing and business capex.
• Wealth: changing interest rates impacts on asset prices, with a flow-on effect to wealth, borrowing ability and spending.
• Cashflow: changing interest rates impacts on debt-servicing obligations, with a flow-on effect to the cash available for households and businesses to spend.
• Exchange Rates: changing interest rates impacts on the relative attractiveness of investing in Australia, with a flow-on effect to the exchange rate.  Changes in the Aussie dollar change the attractiveness of Australian exports for foreigners.  And change the decision whether to satisfy demand from domestic production or imports.

Economists like to say that the lags between changing policy settings and the impact on the economy are “long and variable”.  One reason for these lags is the varying interest-rate sensitivity across the economy. 

Housing is the most interest-rate-sensitive part of the Australian economy.  And the negative impact of rate rises to date is already evident in the housing market as prices fall.  One of the fastest tightening cycles on record is accompanied by one of the fastest downturns in dwelling prices (Chart 14). 

The consensus among the major banks is that dwelling prices will fall a further 8% in 2023 (Chart 15).  Interestingly, forecasts for 2023 are now marginally less pessimistic than those made earlier in 2022.  Nevertheless, the peak-to-trough decline would be of the order of 15%. 

Housing is the dominant household asset.  So the “wealth” channel is in operation.   

Housing is more than just prices.  Residential construction is a significant part of the economic story.  CBA estimates suggest higher mortgage rates have reduced borrowing capacity by around 25%.  Housing lending and leading construction indicators like building approvals have turned down (Chart 16).

So the “savings & investment” channel is in operation.  

There is a silver lining to the housing gloom.  The earlier housing boom accounted for a significant part of the acceleration in inflation rates.  The housing downturn will take some of the steam out of the inflation story.   

The Aussie dollar has tracked within a relatively narrow range during the current policy tightening phase.  The “exchange rate” transmission channel is exerting an essentially neutral influence at present.

The exchange rate is not the only external influence on the Australian economy.  Global central banks are lifting interest rates.  But they are also shrinking their balance sheets.  A Quantitative Tightening (QT) cycle is underway.  Commodity prices show some correlation with the swings in central bank balance sheets (Chart 17).  So QT is a negative for commodity prices in 2023.  Australian incomes would suffer as a result, with a flow-on to government revenues, business investment and consumer spending.

The lags to consumer spending are typically the longest.  And the cash flow channel is typically the most powerful transmission through to consumers. 

The lags reflect the time taken for increases in the cash rate to flow through to mortgage payments (often up to three months according to CBA).  And the time taken for fixed-rate loans to roll off (CBA data suggests about 45% of outstanding fixed-rate loans will roll over to higher rates in 2023). 

A rise in debt service costs reduces the household's ability to spend.  And the effect is probably magnified by a sharp rise in the cost of living at a time of modest wages growth. 

The last iPartners inFocus piece (Australia in 2023: risks and issues) noted that consumer recessions are rare.  The last was in 2008 when consumer spending actually declined.  That consumer recession was associated with a lift in the debt service ratio (DSR) to 10% of disposable income.

A cash rate peak of 3¾% could see the DSR lift to nearly 8% (Chart 18).  Not quite enough to provoke a consumer recession.  But the margin for error is small.

There may be no consumer recession.  But that is where the risks lie.  And rates have gone up far enough that there will be some impact on the consumer. 

As with the economy overall, there are varying sensitivities to interest rate changes across the consumer spending spectrum.

Table 3 provided some estimates of the impact of a 1% change in interest rates on the broad categories of consumer spending.  These estimates are only illustrative of potential magnitudes. They do give some guide to the relative impact of interest rate changes between spending categories.

As you would expect, most components of consumer spending decline as interest rates rise.  Consumer durables (like motor vehicles) and some discretionary items (like hotels, cafes & restaurants) are impacted the most.  Some essentials (like food) have only a weak interest-rate response.  Some spending categories have other drivers that overwhelm the interest rate impact (like health as the aging population pushes spending higher).  It seems that there are some types of spending where we are reluctant to cut back (like new phones and holidays).

Meanwhile, I’m off to see my travel agent!

Disclaimer

This report provides general information and is not intended to be an investment research report.  Any views or opinions expressed are solely those of the author.  They do not represent financial advice.

This report has been prepared without taking into account your objectives, financial situation, knowledge, experience or needs.  It is not to be construed as a solicitation or an offer to buy or sell any securities or financial instruments.  Or as a recommendation and/or investment advice.  Before acting on the information in this report, you should consider the appropriateness and suitability of the information to your own objectives, financial situation and needs.  And, if necessary, seek appropriate professional or financial advice, including tax and legal advice.