More increases in Australian interest rates are likely in the year ahead as the RBA seeks to move rates towards normal levels. The normal level is now judged to be around 5%.
However, the process of tightening is likely to remain gradual thanks to falling underlying inflation and lingering uncertainties about growth.
The AMP’s chief economist, Dr Shane Oliver the cash rate is unlikely to reach 5% until around the end of 2010. Rising interest rates won’t be a major problem for shares until rates reach onerous levels. This is unlikely until 2011 or 2012.
The Reserve Bank of Australia has again increased the cash rate by another 0.25% taking it to 3.75%.
While much will no doubt be made of the fact the RBA hasn’t increased rates three months in a row since the 1980s, it should be noted that 3.75% is still very low for the cash rate in an historical context.
See the chart below.
Bank mortgage rates also remain historically low.
Assuming the average bank standard variable mortgage rate moves up by the 0.25% hike in the cash rate this would take them to around 6.5%.
Apart from in recent months, the last time it was lower than this was briefly just after the 9/11 terrorist attacks and prior to that was in the early 1970s.
While the latest Statement from the Reserve Bank is noncommittal regarding interest rates going forward, the RBA’s generally upbeat tone suggests that more rate hikes are likely if the economy continues to recover as expected.
This is consistent with our own composite leading economic indicator which is pointing to 4% economic growth over the year ahead.
While there was a case to hold fire this month, in terms of the big picture with economic growth heading back above trend there is no need for interest rates to remain at historically low levels, and so interest rates are on their way back towards a more normal level.
The ‘new normal’ for the cash rate
The normal level for the cash rate is basically the level below which monetary policy stimulates the economy, but above which it acts to slow the economy.
So, the big question is what is the ‘normal’ level for the cash rate?
This is important because it may provide a rough guide as to where the RBA is likely to take the cash rate in the next year or so, and it also suggests a level that once we go beyond, monetary policy will begin to constrain the economy and be more of a concern for the share market.
In the past, the normal rate was thought to be around 5.5% to 6%.
In theory the normal level of interest rates should be around a country’s potential nominal GDP growth rate.
So if Australia’s long term inflation rate is going to be at the mid point of the inflation target (i.e. 2.5%) and potential real GDP growth is around 3% then this would imply a normal rate of 5.5%.
Surprisingly, the average level for the cash rate over the period since inflation targeting began is 5.5%.
However, several considerations suggest the normal level of interest rates may have changed.
Two factors are likely to be pushing it up and these are stronger population growth on the back of higher immigration levels, and the boost to national income and mining investment from the commodity boom, which we suspect has much further to go.
Against this though, several other factors suggest the normal interest rate may have declined:
Bank lending rates are running at higher levels relative to the cash rate than has been the case in the recent past.
For example, over the 10 years to December 2007, the gap between the standard variable mortgage rate and the cash rate was 1.8 percentage points.
It is now 2.8 percentage points.
Assuming the gap remains this high, the RBA won’t need to increase the cash rate as much to attain a given level for private sector borrowing rates.
The 1 percentage point blowout in the spread between the mortgage rate and the cash rate would suggest that the normal cash rate is now 1 percentage point lower than it was two years ago.
Secondly, the level of household debt to income has increased in recent years with the result that households are likely to be more sensitive to interest rate increases than in the past.
In other words, the RBA won’t have to increase the cash rate as much to achieve a given slowing in the economy.
Finally, the Australian dollar is running well above the average level that prevailed since the float of around $US0.70 and this will be having a constraining impact on the economy similar to monetary tightening.
Weighing up these conflicting forces suggest to us that the normal cash rate has fallen to around 5%.
With growth improving but underling inflation falling thanks to excess capacity globally, the strong Australian dollar bearing down on import prices and uncertainty remaining regarding the strength of the global recovery, our assessment is that the RBA can continue taking a very gradual approach in raising the cash rate.
In fact, having increased the cash rate 3 months in a row there is a case for the RBA to see what the impact has been before moving again, which suggests that the next hike may not be till next March.
Our view remains that the 5% level for the cash rate in Australia won’t be reached until the end of 2010 and in the absence of inflationary pressures, monetary policy won’t move into tight terri
