RBA May Hike Rates Despite Below-Target Inflation, Edwards SaysBy
Very low rates during times of firm growth ‘invite trouble’
Ex-board member says bond rate should be heading toward 4.3%
The Reserve Bank of Australia could lift interest rates even if inflation remains below its 2 percent to 3 percent target, former board member John Edwards said.
“Very low interest rates at a time of firm economic expansion invite trouble,” Edwards said in a column on the website of the Lowy Institute for International Policy, where he is a non-resident fellow. There is “too great a risk that the price of assets like houses and shares may get too far out of whack with what prove to be sustainable levels.”
Edwards noted that RBA Governor Philip Lowe last month reaffirmed his expectation that gross domestic product growth will be 3 percent over the next couple of years, or a bit higher than the central bank’s calculation of potential growth. The economy’s speed limit is estimated by Treasury at 2.75 percent.
Edwards made waves in late June when he said the central bank could raise rates eight times in the next two years to 3.5 percent in the event the economy met the bank’s forecasts. Three weeks later, the RBA also said the level of the neutral real interest rate -- where output growth is at potential and inflation stable -- was around 3.5 percent. The cash rate has stood at a record-low 1.5 percent since last August.
Referring to the strengthening global economy and the Federal Reserve’s moves to begin shrinking its huge holdings of U.S. government bonds, Edwards said “it seems to me that fixed interest markets are still well behind, or simply unbelieving.”
In Australia, the 10-year bond rate has recently been around 2.6 percent, he noted, or 1.1 percentage points above the cash rate. That compares with its long-term average premium to cash of 0.8 percent.
“So there is perhaps some allowance for a rise in the cash rate over the ten years of the bond, but not much,” Edwards said.
He added that while there is “plenty of room for disagreement” on how quickly the RBA might get to its neutral rate of 3.5 percent, there’s not much dispute that level will be the “new normal.”
“On present trends the RBA might be there in as short a time as two-and-half years or as long as, say, five years,” said Edwards, who served on the board from 2011 to 2016. “Whether it is quick or slow, bonds are not priced for it.”
Indeed, Westpac Banking Corp. Chief Economist Bill Evans reckons the RBA will remain on hold until 2020, forecasting slower growth and weaker inflation than the central bank. Australia’s core inflation rate was 1.8 percent in the second quarter.
If and when the RBA reaches its new normal interest rate, the 10-year bond should be around 4.3 percent, Edwards said. In principle it should already be heading there, but it isn’t, he said.
“That suggests to me that markets don’t really believe the upswing story, even now,” he said. Traders on Thursday were pricing in a 64 percent chance of a rate increase in July next year.
“Markets in Australia and in other advanced economies are perhaps looking at inflation, and rightly reckoning that it might be quite a while before wages and consumer prices growth picks up,” he said. “Maybe so, but if output growth is satisfactory the RBA may well begin to tighten,” he said, citing potential bubble trouble in an environment of strong growth.
Another factor frequently cited as an impediment to early or quick rate rises is high household debt. But Edwards maintains the level is not as heavy a burden as the RBA suggests, because it’s grown slower in the past five years than in earlier periods.
“The build-up of household debt in Australia is interesting and important, but often misinterpreted to suggest Australian households collectively are in a fragile position,” he said. “They are not. Collectively, households in Australia have never been better off.”
The economic or “financial fragility” issue, he said, is how assets and liabilities are spread across households. RBA research has found about one-third of households rent, one-third own their homes outright, with the rest having a mortgage.
The latter is vulnerable to higher rates, though most have had a mortgage long enough for repayments to shrink as a share of their wages, according to Edwards. The research also found the “hardly surprising" information that big mortgages are almost always held by households with big incomes, he said.
“If the cash rate did increase to 3.5 percent, it would still be the lowest nominal cash rate in recent history, other than the last five years and the brief emergency setting after the 2008 financial crisis,” Edwards said.
— With assistance by Garfield Clinton Reynolds