Reality of rising interest rates begins to sink in

I cannot imagine RBA governor Philip Lowe getting up after such inflation numbers and saying that the pandemic emergency 0.1 per cent official cash rate was still appropriate, writes Terry McCrann. Picture: Gaye Gerard

This was the week of a wannabe-PM’s so-called gaffes. Well, they weren’t actually gaffes but exercises in PM-disqualifying ineptitude and incapability.

Further away from the front pages and the 6pm TV shows, this was also the week the reality of rising interest rates began to sink in.

Two peripheral central banks – the Bank of Canada and the Reserve Bank of New Zealand – “surprised” observers by raising their policy rates by 0.5 per cent. The comments emerging from the US Federal Reserve, the central bank that is certainly not peripheral, made it clear it will follow suit at its next meeting in early May.

An announcement will come early on May 5 – Thursday morning, Australian time – two days after our Reserve Bank’s May meeting on the Tuesday.

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Well, the reality of rising rates has sunk in up to a point. The, ahem, “smartest guys” in the (most important) room, Wall Street, essentially yawned.

Yes, both the Dow and the S&P 500 are down so far this month, but there was no sense of impending equities doom. The perceived conclusion? Yes, rates will rise but the Fed “will look after us”.

There is also certainly no expectation of rising rates at the European Central Bank and the Bank of Japan.

Indeed, not only did the ECB explicitly say as much at its policy meeting mid-week, but it is continuing to print money under its QE program, albeit at a proposed reducing rate through mid-year.

Sure, the ECB has a particular problem: the reality of a war on its doorstep; and if that wasn’t destabilising enough “just on its own”, then add on Europe’s massive dependence on Russian oil and gas.

But, simply if bluntly, what the ECB does or doesn’t do is irrelevant to both the global economy and to global financial markets, and the same goes for the BoJ. The only one that matters is located in Washington, but hostage to mid and downtown Manhattan.

This was also the week that a tiny fissure emerged in the general Down Under commentariat that our RBA would persist with what might be termed its Augustinian approach: that yes, it would be raising rates, just not yet.

That’s to say, not yet in May before the election, but in June.

I was gratified to see the AMP’s Shane Oliver take at least a tentative step towards joining me in predicting the RBA would hike in May and not only hike but do the 0.4 per cent that I’ve been arguing it now has to do.

Oliver started by emphasising that “our base case remains that the first RBA rate hike will be 0.15 per cent and come in June”. Then came the “but”.

“But with Australia facing the same risks as in various other countries that inflation expectations will get out of control, locking in higher than target inflation, there is a strong case that a blowout March quarter inflation report (due 27th April) should be met with a rate hike in May and that the first hike should be 0.4 per cent.”

As gratifying as that was, his tentativeness was a tad puzzling, because Oliver went on to predict exactly such an inflation blowout. “We are expecting a 1.7 per cent (quarterly) rise in the CPI and a 1.1 per cent (quarterly) rise in the trimmed mean,” Oliver wrote.

Well, that would deliver a 4.6 per cent full-year headline rate and 3.3 per cent for the trimmed mean.

Far more potently in telling us about current – and possibly portending – inflation, that would mean a 6 per cent headline inflation rate in the March half-year on an annualised basis, and 4.2 per cent for the trimmed mean.

As I’ve been writing, I cannot imagine RBA governor Philip Lowe getting up after such inflation numbers and saying that the pandemic emergency 0.1 per cent official cash rate was still appropriate – even if it’s while he’s waiting to see the next wages data in mid-May.

Critically, arguing that the rate must go to 0.5 per cent and go there now is not to argue that the RBA would or should lift it to 2 per cent or 2.5 per cent.

No, it is first about getting it away from the 0.1, like every central bank in the world should be doing – and in doing, the NZ one is the standout performer.

It is about secondly having a rate which is relevant in the broader context of interest rates in a normally functioning economy.

It is also about having an official rate that gets so far behind the inflation reality – that has the RBA doing the job it is supposed to do – counteracting excess inflation.

All this becomes even more pointed – and as yet, totally undiscussed.

What happens when, especially the Fed and also our RBA, begin shrinking their balance sheets, begin unprinting money.

The Fed’s balance sheet has grown to over $US8 trillion ($11 trillion), the RBA’s to $620bn, as they both essentially funded their respective federal government deficits – albeit pretending not to – by buying the bonds the governments issued indirectly in the secondary market rather than having them issued directly to them.

The Fed’s balance sheet is also stuffed with corporate bonds issued by institutions to fund home lending.

Simply, raising policy interest rates will raise market rates at the short-end; un-printing money – even at the tentative, minuscule pace proposed by the Fed – will raise yields across the curve. And do what to Wall St (and our market)?

I leave you with this. Take a look at the Fed’s balance sheet against the S&P500. There is a striking, ominous, correlation. In 2017, before the Fed started on its current bout of crazy money printing, its balance sheet was ‘only’ $US4.5 trillion (after the GFC money printing, never really unprinted). The S&P index was barely half its current level.