Interest rates – lower for longer?

From

Christian Golding

Until recently central banks around the world have been ironclad in assuring businesses and consumers that they should expect interest rates to remain historically low for years to come. This stance was a critical tool in supporting confidence which helped Australia’s economy survive the tumultuous events brought on by COVID-19. It has also has been key in assisting the economic rebound in consumer spending, business investment and asset prices around the world as we emerge from the shadow of the pandemic.

Although as the world has reopened, this economic momentum has contributed to growing inflationary pressure, leading many market commentators to talk up the prospect of increasing interest rates. The recent spike in local headline inflationary numbers no doubt has also turned some heads in the Reserve Bank of Australia (RBA), forcing contemplation over the possibility of needing to increase interest rates sooner than their initial estimates indicated.

The RBA currently holds an inflation rate target of 2-3%, with this band allowing for sustainable economic decisions to be made. When inflation moves outside of this band for a sustained period, the RBA will implement strategies to increase interest rates, thereby reining in overspending and stabilising the economy.

However, if a central bank implements strategies prematurely or too rapidly then it could have an adverse effect. An example of this was in 2018 when the US Federal Reserve lifted interest rates from 1.5% to 2.25%.

This change, together with the expectation of more rate increases to follow, saw heightened apprehension amongst investors that consequently rattled equity markets. In the last four months of 2018, the US market fell circa 20%, with the Australian market following suit down 15% and housing prices contracted significantly.

As a result, the potential of a repeat of history will undoubtedly be at the forefront of central bank thinking around the world as they attempt to normalise policy, without derailing confidence.

Changes or expected changes in interest rates affect future return expectations on other asset classes in both a positive and negative manner, depending on the type of asset. For instance, cash returns have been detrimentally affected with rates reaching all-time lows, whereas investments in growth assets, such as shares and property, have seen their value skyrocket.

This is due to the nature of how growth assets traditionally increase in price, which occurs in one of two ways – through growth in the earnings of a company or rent of a property, or by a general revaluation against other assets (relative value) such as cash.

The RBA’s stance that interest rates would remain at historical lows until 2024 contributed to a flock of investors competing for property and share assets as lower long-term interest rates reduced the required returns on these growth assets while cheap debt just added fuel to the fire. This environment has contributed to the currently high multiples being asked of stock and property, but much of this revaluation ‘free ride’ is now baked into prices. However, should interest rates start to rise on a sustained basis it will have the opposite effect, creating a headwind for price appreciation of growth assets.

Those potentially most at risk, are first home buyers, who in competition with property investors, have borrowed heavily to stay ‘in the game’ and bid prices higher.

This brings us to the question on everyone’s minds – will interest rates remain low or were we all sold a dream that was never going to become true? The key to answering this question is inflation.

The current hype around the recent inflationary spike is fuelling the debate as to whether inflation is transitory (short term) or more structural (long term) in nature. If transitory, as the RBA and many central banks around the world would have you believe, there is no case for rates to rise in the short term because the jump in inflation is merely a period for recalibration to the reopening of the economy before supply and demand factors return to normal.

However, if inflation is more structural because of higher sustained energy prices, the disruption of supply chains and the reduction in China’s focus on exporting cheap components, the RBA will be forced to lift rates more aggressively to bring equilibrium to Australia’s rebooting economy.

For now, the RBA is certainly not leaving anyone guessing where it stands with its Governor, Dr Philip Lowe reaffirming his expectations that there will be no need to raise rates until 2024.

Central to the current scenario, inflationary pressures arising from factors such as issues in the supply chain and jumps in energy prices are likely to be naturally resolved before inflation becomes entrenched. The expectation being energy producers will increase output while there is already evidence that transportations costs may have already peaked – but both will take time to return to normal.

In Australia, the big inflationary ticket item is wage pressure – and currently there is none.

Even with unemployment continuing to trend downwards, the tighter labour market has not presented itself through higher wages. If tight labour markets persist it would be expected to spill into wage pressure however, increasing automation and globalisation of the workforce through technology will continue to place a headwind on wage inflation getting too far out of whack.

Although there are some who expect rates to rise locally in the next year, thereby creating havoc for asset prices, the prospects of this appear to be more about headlines than trendlines.

A rise in inflation however should not be viewed solely as a negative as it is often an indicator of a strong economic environment which in hand reflects positively on factors such as company earnings and rental income. If inflation remains within a reasonable band then we can expect a robust economy, however, like many things, too much of it creates headaches such as asset speculation, slowed business investment and wage pressures.

It is fair to say that although interest rates are likely to remain low, at least in the short term, as the economy continues to build momentum over 2022 it is likely we will see a move in interest rates earlier than currently expected by the RBA to which asset prices are vulnerable.

By Christian Golding, Partner

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