Why the RBA won’t raise rates until 2020
We are now 18 months into the Reserve Bank of Australia’s (RBA) ‘unprecedented’ decision to set interest rates at 1.5%.
In August 2013, when the RBA dropped rates to 2.5%, most analysts described it as a ‘historical low’.
Come February 2015, when the RBA lowered it again to 2.25%, the key phrase to describe rates was ‘new low’.
At no point did anyone discuss the idea that this might actually be the ‘new normal’.
Instead, since that August three-and-a-half years ago, most analysts have predicted that rates would start going up.
Part of the reason they get stuck on the idea of higher rates is that it signals the broader economy is doing well.
They ignore the fact that the RBA has been dropping the cash rate continuously since October 2011, when it was at 4.75%.
Well, interest rates aren’t going up. Not this year. And probably not next year, either.
This time last year, the general consensus among bank analysts was that the RBA would start increasing rates towards the end of 2017.
That didn’t happen.
Half-way through 2017, it finally became obvious that there was no rate rise coming for the year.
Then, some six weeks into this year, two major Australian banks finally ditched their ‘two rate rise’ forecast for 2018.
Initially, both National Australia Bank Ltd [ASX:NAB] and Australia and New Zealand Banking Group [ASX:ANZ] said they expected the RBA to raise rates in May and November this year. Now they’re saying there’ll be just one rate rise in November.
As far as I see it, that won’t be happening.
The RBA economic models are broken
Heard of the Phillips curve?
Named after economist William Phillips in the 1950s, the curve explains the inverse relationship between the unemployment rate and the rise of inflation in an economy over the short term.
That is, in the short term, falling unemployment should lead to higher inflation.
In other words, as more people gain employment, there should be more money spent in the economy.
Traditional central banking models tell us that if more money is being spent, inflation should begin to rise as well.
Basically, the Phillips curve is the assumption that changes in unemployment have a predictable effect on inflation. Creating the impression that the government can exploit this relationship by allowing it to aim for inflation-based monetary policies.
Following the Phillips curve, the government attempts to stimulate economic demand with monetary and fiscal policies.
Of course, like all things the government tries to control, it often doesn’t work out as planned.
The relationship between inflation and unemployment has broken down several times since the 1960s. One such example was in the US during the 1970s, in which the economy experienced both high inflation and high unemployment.
In Australia, however, the relationship started to crumble around early 2014. Since then, both unemployment and inflation have fallen in tandem.
Australian Unemployment & CPI Rate 2008–2018
Source: Trading Economics
One reason for the relationship breakdown could be that official data doesn’t tell the whole truth.
The official unemployment data from the Australian Bureau of Statistics says that unemployment has hovered between 4% and 6.4% since 2008. The highest reading during this time was 6.4%, recorded in October 2015. Today the unemployment rate sits at 5.5%.
However, alternative statistics from Roy Morgan suggests unemployment has floated between 5.8% and 9.1%, where it stands today. According to Roy Morgan, the unemployment rate peaked at 12.4% in February 2014.
The disparity in employment statistics is no doubt contributing to the Phillips curve breakdown.
The problem is that, for the past few decades, central bankers have relied on the Phillips curve to guide policy decisions. But evidence suggests that one of their key economic forecasting tools isn’t working. Meaning they aren’t quite sure what to do next. So they are left to analyse individual data when it comes to rate setting.
Last week I explained how one bump in wage data does not make a rate rise, in spite of mainstream headlines claiming it adds to the case for one.
Yet that’s only partly the basis for policy decision-making. The other piece of the puzzle is the lack of inflation.
You see, central banks ‘target’ consumer-based inflation. However, the inflation rate is barely moving — or least not moving at a pace the RBA would like.
If the RBA came along and started jacking up rates now, even the smallest increase could scare consumers and reduce spending. If people slowed their spending, the inflation rate would fall again. And the RBA would be back to where they started — bemoaning a lack of inflation.
Yet the RBA have another problem compounding the issue of when to raise rates: the incredibly inflated housing market.
The RBA’s problem in one chart
In the US, the Federal Reserve’s decade-long low interest rate policy saw investors flock to the stock market. In Australia, though, our low rate is propping up other sectors of the Aussie economy.
We haven’t followed our US counterparts by putting our money into the stock market at the levels they have.
Instead, the rock-bottom lending rate means we’ve loaded up on red bricks rather than blue chips.
This has created a massive problem in the form of an expensive housing market.
Even on two incomes, the percentage of disposable income to household interest payments is at alarming levels. And that’s with a current 1.5% rate as set by the RBA.
Source: The Age
In 1990, households had a roughly similar disposable-income-to-interest-payment ratio to today’s 8.9%. Except that 9% of interest payments of income was supported by an RBA cash rate of around 16%.
And what about in 2007–08, when most households were paying around 13% of their income in interest payments? The cash rate hovered from 6.25–7.25% before falling to 3.25% at the end of 2008 due the financial crisis.
Let’s put this data in perspective.
If the cash rate were to rise to 3.5% — 2.3 times what it is today — people would be spending 13% of their income on interest payments on their home.
This puts the RBA in a tricky spot. This massive accumulation of debt would mean that any rate rise is likely going to have a massive impact on many households in Australia.
In fact, if the RBA raised rates by 0.25%, it could have the impact of a 0.75% rate rise.
All this is to say that the RBA doesn’t have the luxury of being able to raise rates. They don’t want to cripple parts of the overleveraged $2.64 trillion mortgage sector.
The RBA simply cannot risk the potential damage that such a rate rise would unleash on the economy.
Not when wage growth is lagging. And not when inflation is barely above 2%.
Sure, there’s an awful lot of noise in the mainstream media about when rates are going to rise. ‘The Fed is raising, so the RBA will have to as well… The RBA will have to rein in the Aussie market…’
Yet none of this is true.
Just because the Fed is increasing the cash rate doesn’t mean the RBA has to follow suit.
What’s more, the increasing scrutiny from financial regulator APRA means our banks are under more pressure to restrict home lending…at least for now.
Until there are several quarters of wage and inflation increases, the RBA isn’t likely to raise interest rates.
That suggests no rate rise this year. And maybe not even in 2019.
And here’s something else you may not have considered:
If both consumer inflation and wages start to fall even a little this year, I reckon the RBA will start making the case for a rate cut.
It’s not all bad news, though. The reality hampering the RBA’s policymaking suggests that investors are going to flock to the stock market.
Cash deposits at the bank aren’t earning anything. Which means that low rates should see more people putting their money in stocks this year.
Co-editor, The Daily Reckoning Australia