Interest rates are going up and won’t come down any time soon. But that’s not the scariest part of trying to beat inflation.
There has perhaps never been more interest in interest rates than there is now.
Not after the Reserve Bank of Australia (RBA) ended an 11-year rate hike drought with back-to-back official exchange rate (OCR) hikes from a record high of 0.1% to 0 .35% in May, then in June at 0.85% – the largest single rate hike since 2000.
Just six months earlier, RBA Governor Philip Lowe said rates were unlikely to rise before 2024. How times are changing.
And as the levels rise, you’d be forgiven for thinking your blood pressure rose with them. Not to mention your stress and confusion as to what it all means and, more specifically, why they keep going up, not down.
That’s the easiest part to explain for economists like Saul Eslake, who says it’s a combination of inflation and a surprisingly robust post-pandemic economic rebound.
“Inflation is rising more – and faster – than expected even six months ago,” Mr Eslake said. “And it’s no longer thought to be ‘transitional’ as originally thought last year.”
In short: the economy rebounded faster and higher after Covid, thanks in part to the historically low cash rate of 0.1% set in the “disastrous circumstances” of November 2020.
“To persist with monetary and fiscal settings designed for very different circumstances would create problems,” he said.
In fact, he said, keeping the rate extremely low for so long contributed to inflation hitting so hard.
“Because – and it’s easy to say in hindsight – governments and central banks have kept doing what they’ve been doing for too long,” Mr Eslake said.
The RBA’s economic cushion has worked so well that the RBA has to work twice to bring inflation down from a 20-year high of 5.1%, which it hit in the March quarter of 2022, at the “normal” – between 2 and 3 percent. hundred.
But the RBA governor told the ABC 7:30 a.m. last week that he expects inflation to climb to 7% by the end of the year, which means the cash rate will have to be much higher than the current rate of 0 .85% to bring it back up to par.
Why? Economists say that because interest rates have to cover expected inflation, and more. The difference between the two numbers is called “real” or inflation-adjusted interest.
In a rare interview with ABC 7:30 a.m.Dr Lowe said it was “reasonable” to expect the cash rate to hit 2.5% by the end of the year – right in the middle of the inflation target – this which would bring “real” rates down to 0%.
Those kinds of observations, Mr Eslake said, prompted some to predict that the cash rate could climb as high as 3.35% by the end of the year under the RBA mission. to control inflation. But, he says, “no one knows for sure” how high or fast rates will rise. Not even the RBA.
“They also don’t really know what the impact of doing what they need to do will be on economic activity and unemployment,” he said, including the RBA’s plans to unwind bonds and assets purchased during the pandemic to reduce longer-term interest. rates.
“So there are a lot of things that central banks [the RBA and others] don’t know, and neither does anyone else. Which means that the chances of being wrong are high.
And what do they risk if they are wrong? An even scarier ‘R’ word. Recession.
“They could drive interest rates up far enough to kill inflation but also tip economies into recession. That’s a risk that is not negligible,” Mr Eslake said.
“That is why one of the particularly important challenges for central banks now is to prevent the development of an inflationary psychology in the population.
“Because history tells us that if people come to believe that inflation will be a permanent feature of life, they will begin to behave in ways that make it much more likely will be be a permanent feature of life.
For example, Mr. Eslake said, this could happen if workers start demanding wage increases to compensate for price increases that have not yet arrived, or if companies start raising prices in anticipation of increases. potential costs.
“And if either or both start to do that, then inflation will go up and it will be much harder to bring it down without causing a really bad recession,” he said, like those in the 1980s and 90.
“It’s kind of a nipped in the bud situation. It’s a bit late, the bud has bloomed. But you don’t want it to start shedding seeds that will produce new inflation buds.
The RBA essentially takes a whipper snipper to an overgrown garden.
And while that sounds like a daunting task, there’s no need for panic among consumers, as there are early signs that the hikes are already working to slow rising costs.
But the rise in rates will not slow down yet.
In fact, Mr. Eslake says rates are unlikely to come back down until the RBA gets us out of this mess.
“[Rates] will not come down here or anywhere else until it is clear that inflation has come down to the levels targeted by central banks,” he said. So between 2 and 3%.
And they are unlikely to go as low as 0.1, until the next super international emergency.