October 2022

In September, the RBA decided to raise the cash rate by a further half percentage point (taking it to 2.35%). It was only in April that the cash rate was 0.1% so the move up has been rapid-fire. The reasons for the aggressive shift in policy are well known: the economy is performing well, inflation is too high, and interest rates were too low.

The minimum requirement was that interest rates needed to move up to a more ‘normal’ level. But the concept of what is a ‘normal’ interest rate is a mythical economic beast, one best spotted in the rear-view mirror of historical economic data. The movement of equity and house prices and the pace of credit growth made it pretty clear that a ‘normal’ level of interest rates is comfortably above zero.

Worries about what is the ‘normal’ level of interest rates in some respects is of academic concern. The right level of interest rates is the one that helps get inflation back to target (2-3%). To complicate matters, how high interest rates will need to rise will depend upon a range of factors including how business and consumer confidence evolves, what happens with fiscal policy as well as movements in supply chains (notably for commodity prices).

It will also depend upon what is happening to interest rates in other major economies. The RBA (and all central banks) make the point that monetary policy is set upon what is happening in the domestic economy. But in a globalised world, major events have global consequences (such as what is currently happening with commodity prices). That is one reason why Australian interest rates often move with global interest rates (proxied by what happens in the US).

It is true that Australia currently has lower wages growth than the US (as well as other countries such as the UK, New Zealand and Canada). Given how low the unemployment rate is, it is a bit of a mystery as to why wages growth in Australia is not stronger. Government restrictions on public servant pay rises have played a role (this is changing). Wages growth in Australia does appear to be less volatile than in peer countries. This has been put down to how wages growth is determined in Australia (through a mixture of awards, enterprise bargaining and individual contracts) which means it takes longer for changes in labour market conditions to impact wages growth.

Research suggests that it is financial market views on where prices are heading tend to provide the best indicator of future inflation. The good news is that at present financial markets expect inflation to decline back towards the RBA inflation target over the next couple of years and remain there over the medium term.

And there are reasons to think that inflation will return to the RBA’s 2-3% target band. Unit labour costs (labour costs after considering productivity) is currently consistent with inflation of around 3%. The difference between consumer and producer prices is around its long-term average. It is also possible (but not certain) that the demand for workers has peaked (albeit at a very high level) although the labour market remains very tight.

Another issue is the lag between rising interest rates and the impact it has on the economy. Monetary policy has always impacted the economy with a long and variable lag. But in this cycle, the reasons for the lags are more obvious. The high level of saving by households (and businesses) means many can absorb a fair bit of the increase in the cash rate. The high rate of fixed-rate lending done over the past couple of years means that those households will not be exposed to interest rate changes until those loans expire (a big lump of which starts next year).

Currently, financial markets are pricing the peak of the cash rate to happen in the first half of next year. But many of the impacts of higher interest rates may not be fully felt until the second half of next year. That could mean the RBA could be faced with some challenging choices in the first half of 2023. But given the economic lags it also likely means that cuts in the cash rate are unlikely before 2024.