- There has been a forty-year downtrend of the cash rate in Australia;
- This has been caused by both a decline of inflation and ‘real’ interest rates’
- And most likely the cash rate will remain at its current level for the next couple of years;
- But the groundwork is being laid for a (modest) shift higher of interest rates.
For forty years interest rates have been on a declining trend. That decline has mainly reflected two factors: slowing inflation and falling ‘real’ interest rates.
Most of the trends for lower inflation have been in place for some time. But in combination with the weakness of global economic growth post GFC it has resulted in global central banks (and most economists’) to overestimate inflation and wages growth outcomes for much of the past decade. The result has been lower interest rates.
There has also been a substantial decline in ‘real’ rates. A fair bit of the discussion has revolved around a fall in the demand for funds (which would drive interest rates lower). But I think it is more likely to have been a result of a rise in global saving (increasing the supply of funds). That rise started in the late 1990’s. In more recent years central banks’ QE policies have played a role.
It can’t yet be ruled out that the forty-year trend decline in interest rates has further to run. One clear possibility is that the recovery from COVID ends up being slower and more prolonged. A bigger risk for rates heading lower in my view is the significant amount of global debt. High debt levels means that Governments and central banks can’t let ‘real’ interest rates get too high otherwise there would be a large number of defaults.
But the bigger picture is that many of the things that you would need to see to get a change in the interest rate trend are now getting in place (with the exception of high debt levels). A growing number of Governments around the world are getting less worried about budget deficits. Many central banks (including the RBA) are explicitly aiming for stronger growth, lower unemployment, higher wages and higher inflation. There are cracks appearing in the global trading and financial market systems. Global investment spending will continue to be strong, driven by infrastructure demands and a need to de-carbonise economies.
A change in the interest rate trend may not be obvious for the next 1-3 years as we move through the final stages of COVID, the debate about whether price rises are temporary or permanent and the impact of Central Banks’ reducing has on asset prices (such as equities).
The very long-run trend of interest rates has been down (due to improvements in communication and transport). But around that long-run trend there has been cycles where interest rates head up, as well as down. It looks increasingly likely that the groundwork for a trend shift towards (modestly) higher rates is starting to be laid.
To read my full update, click here.
We live in interesting times.
Peter Munckton - Chief Economist