Why we will probably never see rock-bottom figures again
The financial markets’ final message to mortgage customers is clear: Don’t expect any further cuts in mortgage interest rates.
That story is likely to get stronger Tuesday, when the Federal Reserve, led by Gov. Michele Bullock, holds its final board meeting of the year. Investors are almost certain the cash rate will remain unchanged, and many RBA watchers believe rates will remain unchanged for some time, perhaps even into next year.
Who knows whether they are right or not; Even the Federal Reserve can’t be sure exactly where interest rates might move from one board meeting to the next.
But if you step back from trying to predict what the RBA might do at this meeting or the next, you can be more confident about a longer-term trend: barring a crisis, we are not about to return to the era of very low interest rates at the end of the last decade, let alone the zero-interest world that came thanks to COVID-19.
For those who have forgotten, the second half of the 2010s and the first years of the 2020s were a period of very cheap borrowing. The cash rate has remained below 2 percent for years and fell below 1 percent in 2019. Later, borrowing became even cheaper when the Covid-19 emergency in 2020 raised fears of a major depression and pushed interest rates to near zero.
There are probably a few reasons why we won’t return to an era of such cheap money. However, what attracts the most attention of economists these days is the concern that our economy is operating close to its “capacity”, meaning there is less room for interest rate cuts.
When economists talk about the “spare capacity” of an economy, they are basically talking about the ability of firms to access the labor and capital needed to meet demand. If there is not enough capacity, such as a shortage of skilled personnel, this triggers inflation as firms compete for available workers. Excess capacity causes low inflation.
The level of spare capacity in an economy is of great importance, given that central banks such as the Federal Reserve direct interest rates to target inflation. It is very important in terms of interest rates.
A large reason why interest rates were so low in the late 2010s was due to large amounts of “overcapacity.” Unemployment was higher; it was often above 5 percent, as opposed to today’s 4.3 percent. The RBA’s main problem was that inflation was below its target range of 2 to 3 per cent, so it tried to increase economic activity and inflation by using its main weapon, namely lowering the cash rate.
From these already low levels, the pandemic has forced central bankers around the world to do whatever they can to prevent a complete meltdown. Rates dropped even further. When the crisis receded and inflation set in, interest rates could not remain at immediate low levels, so central banks turned to this weapon again. The RBA increased rates by 4 percentage points from 2022 before embarking on a cycle of cuts at the start of this year.
Fast forward to today, and many people think this rate-cutting cycle is over after just three 0.25-point cuts. Some economists are even talking about increasing interest rates. Why did the RBA have to quickly switch from rate-cutting mode to potentially considering increases?
The obvious reason for this is the recent rise in inflation. The bigger concern is that this is happening because the economy is hitting those dreaded “capacity constraints.”
As CBA chief economist Luke Yeaman said in a recent note, the economy is starting to recover and there is less spare capacity than in previous economic cycles.
Instead of the unemployment rate being above 5 percent as we did for most of the 2010s, it is now lower at 4.3 percent. More people working is good news, but it also means it’s easier to meet the capacity constraints that cause inflation. This also means that relatively small cuts to the cash rate could risk triggering inflation. “The RBA will need to remain ‘vigilant’ for this risk, meaning interest rates cannot fall that much and rates must remain higher than in past cycles,” Yeaman said.
Moreover, concerns about lack of capacity are not the only reason we think we will not return to the age of cheap money.
The second and more global reason to think that the world is behind us is the economic concept called “neutral interest rate”. This is actually the interest rate level that neither stimulates nor slows economic growth.
“Neutral rate” is a bit of a slippery concept: We don’t know exactly what that number is. But the point is that economists thought the neutral interest rate had been falling for decades and had been rising recently.
Why might this happen? Over the long term, economists think global interest rates are determined by the balance between savings and investment: More savings will push rates down, while more investment will push them up.
One of the theories about the very low rates in the 2010s was that the aging population was saving heavily, as well as a lack of investment, for example.
But lately economists have been pointing to major global forces that would increase the “neutral” rate, such as rising investments.
RBA deputy governor Christopher Kent said forecasts for Australia’s neutral interest rate had risen by around 1 percentage point in October.
Reasons for this increase in neutral rate estimates could include “increasing global public debt, lower savings as Baby Boomers retire, and increased public and private investment, including the shift to green energy,” Kent said.
Other megatrends driving investment around the world (not named by Kent) include a rush to build data centers, higher defense spending by governments, and a rise in companies “supporting” or expanding domestic production. If all these investments cause a change in the balance between savings and investment, it could cause interest rates to rise even further.
To be fair, these are multi-year trends, so they won’t impact short-term interest rate movements. But over the long term economists think our neutral rate has increased, which suggests the real cash rate set by the RBA would also need to be higher to have the same effect.
The bottom line for borrowers is this: Unless there’s some sort of economic emergency, don’t expect interest rates to return to their late-decade lows.
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Clancy Yeates is deputy business editor. He covered banking and financial services and was previously a national business correspondent in the Canberra bureau.Connect with: excitement or email.
