Why the ‘free money’ party is over

Reserve Bank Governor Philip Lowe. Picture: Getty Images

The Reserve Bank remains adamant that it won’t lift its official interest rate until 2024 at the earliest. Its big brother in Washington, the Fed, seemed to waver mid-week on its similar promise, seemingly signalling that it would start to lift its policy rate away in 2023.

What the RBA does is most fundamental to property owners and investors: the utterly unprecedented “free money” of 2 per cent home loans has driven the rise and rise in property values across Australia but most potently in Melbourne and Sydney, where the million-dollar house is now almost de rigueur.

What the Fed does is the fundamental underpinning of all asset values, pretty much globally, but most particularly Wall Street and so our sharemarket.

After the Fed’s “signal” (at 2pm Wednesday Washington and New York time, while the market was still trading), the market dipped barely by a rounding error. Fed head Jerome Powell quickly promised the Fed would keep pouring in ever-more 150-proof monetary hooch.

I believe both central banks will be required to raise their policy rates before 2024; in the case of the Fed well before 2024.

Whether they will and both how timely and then how quickly, though, is an altogether different and more challenging question. That’s why I wrote “required”. I’d be far more confident that the RBA would act when required than that the Fed would – indeed, will.

Understanding the dynamics of all this and so the risks and challenges that investors now face around rates, you need to start with the very different structure of the RBA and Fed forecasts that both deliver each’s rate message and shape market responses.

Every three months the RBA gives us real forecasts. They are done by staff overseen by governor Philip Lowe and his deputy Guy Debelle, based on modelling and core assumptions about the economy.

That is to say they are what the RBA, on the combination of computer modelling and analytical expertise, really believes is likely to happen to the Australian economy.

So, the RBA really believes that inflation will struggle to even get to 2 per cent far less stay above it, to say nothing of accelerating higher, until deep into 2023; after entirely temporarily popping up to 3.25 per cent in the year to this month due to the “events” of last year.

This is because it sees wage increases struggling to get much above 2 per cent until late 2022; on the basis that the jobless rate has to fall significantly below 5 per cent for that to happen.

Hence Lowe’s Costello-like exhortation on Thursday to employers to “take one for the team” by not resisting wage rises.

Yes, narrowly the RBA wants higher wages, (moderately) higher inflation, and so a higher policy rate. But the real objective is the Keynesian orthodoxy of a better-functioning economy – fuller employment, more productivity, rising living standards – from a “little bit of inflation” greasing the wheels.

So the issue with the RBA and its policy rate – and what it does with its QE, its buying of government bonds and its targeting of, currently, the (now, slightly sub) three-year yield – is whether it proves right in its forecasts.

I believe, subject of course as always to “events”, that wages growth and inflation will come higher, faster and more sustainably than the RBA.

I also believe that the RBA will “do its job”; that if my scenario emerged, it would ditch its 2024 promise and move sooner, as needed, as it saw it.

The Fed is an altogether different and seriously disturbing – I would add, disgraceful – matter. Since the mid-1990s it has allowed itself to become totally hostage to Wall Street. It always either buckles into any potential serious market fall or immediately reacts to any such “temper tantrum”.

Far from snatching away the punchbowl when the party gets too boisterous, the Fed now sees its role as hosing in more monetary hooch when so ever the party flags; and, since the GFC, to increase its potency from 75 to 100 and post-pandemic 150-proof hooch.

Understanding this is the key to understanding the Fed. It is also important to understand that its forecasts are not forecasts at all, like the RBA’s.

They are simply the collation and averaging of the individual projections of all the Federal Reserve Board members and Federal Reserve Bank presidents – much like, and with pretty much the same accuracy, as collecting forecasts from market economists or indeed the weekly office footy tipping.

It’s not “the Fed” forecasting that its policy rate will go up 0.5 percentage points in 2023; but simply the (median) average of two dozen-odd forecasts.

The worth of those forecasts was shown by how not a single one of them saw coming the inflation that has erupted in the US this year even as it was erupting.

In March the highest individual inflation forecast was 2.6 per cent for 2021. In just five months to May it’s already totted up to 2.7 per cent.

So after not seeing inflation as it was erupting all around them, all of them – all of them – confidently predict it will subside next year and subside even further in 2023. The highest forecast for 2022 is 2.5 per cent and then 2.3 per cent for 2023.

So, first, you have to contemplate whether the Fed – both collectively and individually – has a clue. I suggest it has demonstrated it is utterly clueless. I suggest it faces a rude, a very rude, inflation awakening.

Then you have to factor in the confused chaos that will result.

First, what the Fed does when reality becomes unavoidable. Will it hike (and terminate QE)? I suggest it will be late and reluctant.

Then how Wall Street behaves – initially feeding into the emerging reality and Fed inaction; then in reaction to any Fed action; and then more interplays between Fed and Wall Street.

It will be a mess and ugly, very ugly.