Interest rate cuts are no certainty
There’s a lot riding on financial markets getting it right with their bet that central banks will cut interest rates this year, led by large cuts in the US.
There’s a lot riding on financial markets getting it right with their bet that central banks will cut interest rates this year, led by large cuts in the US.
Significantly, the rate-cutting expectations embedded in financial markets reflect a view that inflation will continue to head back to central banks’ targets without a marked rise in unemployment.
Not only would borrowers benefit from the lower cost of servicing their mortgages, which in Australia has seen possibly 15-20 per cent of variable-rate owner-occupiers drawing on financial reserves to keep their heads above water, but households more broadly would benefit from more manageable rises in the cost of living which were more than offset by increases in wages. And jobs would still be relatively plentiful.
Rate cuts in the US, the lead global economy, could be expected to follow in short order elsewhere, including Australia.
Indeed, since the middle of last decade there has been a very high correlation been movements in official US interest rates and in Australia.
In fact, since 2019 the correlation has been virtually one-to-one, reflecting the close inflation and labour market outcomes in the US and Australia.
However, history would suggest that such a happy combination of events is difficult to achieve, particularly as one of the drivers of the breakout of inflation since the pandemic has been strong demand, fanned by ultra-stimulatory monetary and fiscal policies.
Across a range of economies, demand still appears relatively resilient, with labour markets remaining tight.
Consequently, premature easing of monetary policy could set off a new cycle of rising inflation, forcing central banks to reverse any rate cuts.
And it’s not as if financial markets always get it right. For example, at the start of last year financial markets were pricing two 25 basis points rate rises by mid-year, with those rises reversed by the end of the year. The actual outcome was a long way from that.
The Fed lifted official interest rates four times last year and did not cut rates. In Australia, markets anticipated three rate rises by the RBA last year but the bank overdelivered on these expectations, lifting the cash rate five times.
Moreover, central banks are not forecasting the deep rate cuts priced into financial markets.
The median of the so-called dot plot of US Federal Open Market Committee member forecasts is for three 25 basis points rate cuts this year.
This is a long way from the six cuts currently priced in US financial markets.
In Australia, the RBA is yet to provide any hint it is considering rate cuts. Indeed, its guidance is that further tightening of monetary policy may be needed to ensure that inflation returns to the target of 2-3 per cent “in a reasonable time frame”.
Reflecting this, financial markets are more cautious about the prospects for rate cuts by the RBA this year. Currently two rate cuts are priced by the end of the year, with the first not until August.
Interestingly, this is more consistent with the three US rate cuts in the Fed’s dot point, rather than the six priced into US financial markets.
How likely are two rate cuts by the RBA later next year?
The good news is that inflation is continuing to move in the right direction and slightly faster than expected.
The monthly CPI indicator eased further in November and is continuing to follow the favourable lead from lower US inflation.
The latest local data also tentatively suggest that both headline and underlying inflation will end this year slightly lower than the RBA’s forecast of 4.5 per cent.
If inflation does continue to track in line or better than the RBA’s forecasts, then the market’s expectation of two 25 basis points rate cuts could be justified.
This would still leave the nominal cash rate above the inflation rate, thereby helping to unwind structural distortions from the low money era.
But the RBA is also forecasting only a marginal rise in the unemployment rate from the current 3.9 per cent to a peak of 4.3 per cent.
This implies only a mild easing in the tight labour market, posing a risk to the inflation outlook, as does the stimulus from the large legislated personal tax cuts from the middle of the year.
As a result, the case for rate cuts is still very much data- and event-dependent and unlikely to be resolved anytime soon.
Paul Brennan is Suncorp’s chief economist.