Australian Economy

Why Reserve Bank governor Philip Lowe is talking tough on inflation

So, given US inflation has been so much higher, for so much longer, why are financial markets expecting the Reserve Bank to lift its cash rate to match the Fed’s short-term interest rate target by mid-next year?

Part of the reason could be that financial markets simply expect the Reserve Bank to follow in the Fed’s footsteps, which will push the cash rate to the same level as the Fed’s short-term interest rate.

Change in language

But it is also likely that financial markets are being excessively influenced by the difference in the language that is being used by the two banks.

Earlier this month, Lowe issued a blunt warning to businesses and consumers to prepare for a string of interest rate rises after the Reserve Bank lifted rates for the first time in more than a decade.

Speaking at a press conference after the decision to lift the cash rate from a record low of 0.1 per cent to 0.35 per cent, Lowe said “the evidence that we have received on inflation has been clear; inflation has been high, and it’s been higher than we’re expecting”.

And, he noted, it “was not unreasonable to expect” interest rates to eventually rise to 2.5 per cent.

Lowe’s warning had the desired effect on consumers. They heard his message that their mortgage rates were about to push higher, and that they would be left with less money in their pockets. Not surprisingly, consumer sentiment quickly soured.

US investors worried

From a central banker’s perspective, this would not be an altogether unwelcome development. Faced with the prospect of future belt tightening, consumers tend to rein in their spending, and this decline in demand helps to cool inflationary pressures.

This means the Reserve Bank won’t have to lift interest rates as aggressively to control rising prices.

But central bankers know that such blunt language can only be used when consumers and investors are sanguine about the economic outlook.

In the United States, investors are worried that with inflation at its highest level in four decades, the US central bank could go too far as it tries to slow the economy to temper inflation, and end up pushing the US economy into recession.

As a result, Jerome Powell, the head of the US Federal Reserve, has been careful to reassure consumers and investors that he is not in favour of taking outsized steps when it comes to raising interest rates.

At a news conference this month, Powell signalled that the Fed could continue to approve increases as large as half a percentage point, but was clear that a larger increase – of 0.75 percentage points – was not something the US central bank “is actively considering”.

Housing market optimism

Of course, Powell’s caution also reflects a desire not to shatter confidence in the US sharemarket. Although he has acknowledged that getting inflation down to 2 per cent will involve “some pain”, he wants to avoid a situation where investors become spooked about looming rate increases and dump shares, triggering a sharemarket collapse.

Lowe, on the other hand, need not worry that even muscular warnings about future rate rises will derail economic activity. That is because in Australia, consumers’ sense of wellbeing comes from the housing market, rather than the interest-rate-sensitive equity market.

Lowe knows that a 25 basis point increase in interest rates by itself isn’t going to do much to puncture optimism in the housing market. And that’s why he’s been keen to emphasise the likelihood of a succession of rate rises.

That’s been enough to send a shiver down the spine of Australian households, which are among the world’s most indebted. The total debt owed by the nation’s households amounts to a staggering 120 per cent of gross domestic product.

But this hefty debt burden – and the low level of long-term fixed-rate loans – will make Australian households much more responsive to even modest interest rate rises.

This, of course, reinforces the argument of Commonwealth Bank chief Matt Comyn that the Reserve Bank’s eventual rate rises will be far less severe than the market is anticipating, and that homeowners may be worrying needlessly.

Financial markets expect the cash rate will climb above 3 per cent next year, but Commonwealth Bank economists expect the Reserve Bank will be much less heavy-footed in applying the brake.

They project the cash rate will climb to 1.60 per cent by February 2023, then remain at that level for the rest of the year.

As they argued in a recent note, the Reserve Bank wants the economy to remain strong, with annual wages growth of about 3.5 per cent (well above the pre-pandemic norm of 2.25 per cent).

“We believe they will achieve this outcome on the basis that the tightening cycle is not overly aggressive,” they wrote.

In contrast, US inflation is higher and more entrenched. That makes it unlikely the Fed will be able to bring US inflation under control without pushing real (inflation-adjusted) interest rates into positive territory.

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