Why we will probably never see rock-bottom figures again

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.

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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.

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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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