Recent ructions in financial markets have been attributed in part to an end of the long phase of falling interest rates around the world. In this scenario, the US Federal Reserve (Fed) raises its funds rate at its policy meeting next week and other central banks, including the RBA, that have mostly been easing policy stop. Most central banks also talk aloud about how monetary policy easing has been stretched to impotency or worse in priming economic growth and in future their political masters will need to do more policy heavy-lifting with budget spending. No more monetary policy easing plus a rising government debt funded lift in budget spending around the world could produce a marked rise in government bond yields and an end to the lower for longer interest rate world, but we have significant doubts whether this will happen over the next year-or-two. Instead, it seems likely that central banks, whatever they wish might happen to reduce their policy burden, will be left with more work to do to try and support growth.
Risks of the Fed lifting to early
The policy guidance from central banks appears to have changed. In the case of the one key central bank that has started to lift interest rates (the US Fed) there has been more talk from senior officials on balance on the need to act sooner rather than later lifting the funds rate, although there has also been well-reasoned contributions too on the asymmetry of risks to the US economy from lifting rates – delaying rate hikes is unlikely to add to over-heating risk, but moving too soon could snuff out the still quite fragile economic recovery. The greater risk that higher US interest rates relatively quickly reduce US economic growth implies that if the Fed does get away another rate hike soon it becomes part of the reason why it may be the last ahead of the Fed needing to reverse direction in 2017.
Issues to potential U.S expansionary government spending
What about if the US moves to expansionary government spending apparently on the wish-list of both candidates in the November presidential election? The chances seem very slim unless one or other presidential candidate manages a very unlikely clean sweep for their party in the lower and upper house elections too. Even then factions in both the Republicans and Democrats to stop the President spending freely are strong. Even if these high hurdles are surmounted, the legislative battle to promote freer spending cannot start until mid-2017 for the budget year starting October 2017 and even then there are long lags before the spending starts to influence US growth. Nice idea to place more policy burden on the fiscal rather than the monetary policy side, but in the US context in the current and future political climate incredibly hard to achieve. If the Fed tightens too quickly and breaks US economic growth it will own the mess and will have to mop up after.
ECB – “Done what we can”
Outside the US among some of the key central banks continuing to ease monetary policy the September European Central Bank (ECB) policy meeting and comments by President Draghi after seemed to imply a change from “doing whatever it takes” to drive growth to “done what we can”. Given that European economic growth is showing signs of flat-lining around 1.6% y-o-y, that progress reducing Europe’s unemployment rate has stalled of late at a still very high 10.1% and inflation is still stubbornly low (0.2% y-o-y) the chances are that the ECB will have to revisit what tools it has to ease monetary policy further.
RBA favourable on Australian growth prospects
The RBA too is showing signs that local interest rate easing cycle may be over. The speech this week by RBA assistant Governor Kent titled “After the boom” takes a comparatively favourable view of Australia’s growth prospects, based on a view that the two biggest headwinds to Australian growth, the fall in the terms of trade and the rundown in mining investment spending are abating. Our view is that is a big call to say that industrial commodity prices will hold the gains of the last few months, because future supply, especially from Australian companies, outweighs what improvement in demand seems likely from China in particular. If commodity prices still have at least one more significant down-leg ahead and excess Australian mining supply requires further cuts to mining investment spending plans, as we think likely, the abatement of big headwinds to growth currently in RBA thinking about the economic outlook is likely to be revisited at some stage. Of course it takes evidence and time to change the RBA’s thinking and it is now less likely that the RBA will cut the cash rate again this year, even if the Q3 CPI report in late October still shows very low inflation.
RBA likely to cut again in 2017
The paradox is that the absence of another cash rate cut over the next few months increases the likelihood that the RBA will have to cut the cash rate more in 2017. What upward blip there is in interest rates around the world in the next month or two while central banks appear to have changed course will feed through to Australian interest rates and credit spreads. Upward pressure on Australian bank lending interest rates will build and with no Australian cash rate change banks will probably lift their variable and fixed interest lending rates before the end of 2016. Housing activity in Australia is already showing increasing patches of weakness which may become more pronounced as interest rates rise, generating weaker household spending in 2017, faltering economic growth and a pressing need for lower interest rates.
Central banks may be wishing they could put the world of very low, asset-price distorting, interest rates behind them, but the fragility of what economic growth there is around the world and in Australia combined with still considerable and price-crushing excess productive capacity means that any significant push up in interest rates quickly promotes conditions pushing interest rates back down again.
Great article and excellent read. Thanks for sharing and a very timely piece of analysis.