Why Australians don’t need to panic about a possible interest rate hike as the RBA mulls the next step
They say talking is cheap, although in recent years it hasn’t been as cheap as money.
For months now, the money mandarins of the world have been sounding the alarm that the great global free money experiment is coming to an end. And in recent weeks, their cries have become more strident. Interest rates will rise earlier, faster and to higher levels than expected.
Last week it was Jerome Powell, head of the most powerful central bank, the US Federal Reserve. He was assisted by Tiff Macklem, head of the Bank of Canada. And on Tuesday we will hear from our own Philip Lowe, the great kahuna at the head of the Reserve Bank of Australia.
Their warnings caused panic in global stock markets. Some of Wall Street’s biggest tech stocks have fallen 30% from their peak and the carnage has spread across the globe. For a brief period last week, the Australian market plunged into correction territory after losing more than 10% from its August 2021 high.
There is now no doubt that the pandemic has changed the course of history, or at least has been the catalyst for a long overdue shift in the tectonic plates of the financial world.
But before you hit the panic button, it might help to sit down and relax a bit. Because unless you’ve dived all into very high-risk investments, like tech companies that aren’t making money, chances are you’ll survive the change just fine.
For starters, the turnaround began just over a year ago. It’s just that central banks didn’t believe it and did their best to ignore it, loudly proclaiming that interest rates wouldn’t be raised for years. Stock traders, emboldened by assurances, continued to buy blindly, pushing stocks further into orbit.
Unfortunately, the interest rate horse is already off and the official rate hikes that are about to begin are only catching up.
Central banks lost control a year ago
This is an easy mistake to make; believe that central banks are all powerful and dictate the direction and magnitude of interest rate movements. And for most of the last half century, they have.
But they lost control a year ago, and while they’re still a powerful force in the market, they’re far from omnipotent. See the chart below, in the market where interest rates are actually set; which dictate to banks the rate at which they can borrow and lend.
See that little blip at the end? It was the turning point in a 40-year cycle of rate cuts that happened around February last year.
A year ago, the rate on 10-year government bonds – often called the risk-free rate because it is a government-backed IOU – was just 0.6 %, not too much above the RBA cash rate of 0.1%.
Over the past 12 months, bond market traders have ignored the Reserve Bank’s insistence on keeping rates unchanged until 2024. Instead, concerned about rising inflation, they have pushed rising market rates, which is why all those incredibly cheap fixed rate mortgages suddenly disappeared. . Last week, this 10-year government bond hit 2%.
It’s the same story all over the world. In Germany, until last week, government bond rates had been below zero for years. It’s just ridiculous, at odds with 5,000 years of human history and any sense of logic.
It is also dangerous. Ultra-low, zero and negative interest rates have distorted global finance, pushed investors into ridiculously risky investments and artificially inflated stock prices and real estate. They also punished savers, anyone who wanted to park money with minimal risk.
The shift was imposed on us, not by central banks, but by the specter of inflation that has slumbered since the 1990s.
Why has inflation returned?
That’s partly because the forces that drove it down relentlessly have subsided.
Much of it is linked to China. The rise of the Middle Empire was born of its industrialization. It quickly transformed from a rural economy to an export-based industrial powerhouse.
Gathering its low-cost labor, it produced everything from clothing and footwear to tools and heavy machinery and, ultimately, high-tech communications. And because they were produced on such a massive scale, he could export them at prices well below the cost of production in the developed world.
Entire industries ripped up stumps and moved to China. Essentially, its main global export was lower prices.
This had another effect. As workers in the developed world lost their jobs, unemployment rose, the power of unions was crushed and wages stagnated. Add to that the rise of the internet and the digital economy, and even skilled workers could be recruited overseas and online, further driving down wages in developed countries.
This allowed central banks, which took over management of the global economy in the 1980s, to continue cutting rates, especially in times of crisis. There was the Asian financial crisis of 1997, the Dotcom collapse of 2001 and the global financial crisis of 2008. Until they finally ran out of ammunition with zero interest rates.
These trends have largely run their course.
Rising geopolitical tensions have prompted calls for more home production, whatever the cost. And China’s shift to the developed world has seen its own workers demand higher wages, limiting the extent to which it can maintain a cap on export prices.
Add to this turbulent mix, the most immediate factors. The COVID-inspired global recession has brought a deluge of government stimulus and trillions of dollars in newly minted cash in an effort to mitigate the impact of lockdowns and disease.
As the world emerged from recession last year, all that extra money boosted demand for goods, the supply of which was constrained by shipping issues and production delays. Prices started to skyrocket.
The US inflation rate has now jumped to 6.8%, its highest since 1982. Across the Tasman, New Zealand – which has already hiked interest rates – recorded last week a 5.9% rise in consumer prices, the largest in three decades. At home, our headline inflation reached 3.5% for the December quarter, much higher than expected.
No pay raise, no rate hike
If ultra-cheap money were creating all of these asset bubbles – house prices soaring and stock markets at nosebleed levels – then surely logic would dictate that more expensive money burst and we will all be ruined.
This is a distinct possibility. But it’s further away than many would have you believe. Stocks could fall further, especially companies with too much debt or with little earnings.
But for all their rhetoric at the moment, central bankers have been remarkably coy about raising rates. And for good reason. They are fully aware of the consequences of a mistake, especially in terms of housing.
Dr. Lowe, making his first outing this week, will be keen to insist that we need to see wage growth before there is a substantial rise in interest rates. So by the time your mortgage rate goes up, perhaps later this year, you should be able to cover it with a bigger payout.
This is going to be crucial for the legion of first-time buyers, many of whom took out loans six times their income, who took the plunge last year in a borrowing spree encouraged by our monetary mandarins.
In any case, much of our newly acquired inflation is the result of global shortages of building materials and fuel. It is not fueled by sustained excess demand.
Pushing interest rates higher right now would not lower these prices. This would likely only push the economy back into recession, which would mean rates would have to be cut again.
Unemployment has fallen to 4.2 percent and there is anecdotal evidence that wages have started to rise. But don’t expect any official rate hikes until later this year, until there’s solid evidence that wages are finally out of the doldrums.
Unraveling the distortions created by free money will not be easy or quick. And it will not come without pain or casualties. But it is absolutely necessary.