The Reserve Bank of Australia (RBA) has developed a reputation in recent years that it’s a “half-glass-full” central bank.
In a sea of negative headlines and commentary about the outlook for the Australian economy, it has retained an optimistic view on where the economy is heading.
Just look at the bank’s most recent economic forecasts offered in its May statement on monetary policy underlining that point.
It’s an optimistic assessment if there every was one, with economic growth and inflation both expected to increase moderately over the next few years.
Aside from pondering whether or not those forecasts are too optimistic, which many are already doing, the other question markets, businesses and households will be asking is what, should the RBA be proven correct, will it mean on the outlook for domestic interest rates?
According to ex-RBA board member John Edwards, it means that interest rates will not only increase, they’ll go up a lot.
Yes, in his opinion, “the time is coming to get back to normal”.
“If inflation does indeed return to 2.5%, as the Bank now expects, if growth does indeed return to 3% ‘within a few years’, as the minutes of the June board meeting predict, if the world economy is indeed picking up, then a policy rate of 1.5% is too low,” he wrote in an article posted to the Lowy Institute’s website earlier this week.
“It seems to me that something like eight quarter percentage point tightenings over 2018 and 2019 are distinctly possible, if the RBA’s economic forecasts prove correct.”
Obviously the RBA’s glass-half-full mindset runs deep within its board members, even once they’ve left.
Eight 25 basis point increases would leave the cash rate at sitting at 3.5%, a level that many already deem to be above the current neutral level where monetary policy neither curtails or adds to economic demand.
While Edwards admits that this level may be “markedly lower than in the past”, he says that at 1.5%, the current cash rate is less than a third the average policy rate of 5.2% seen over the past two decades.
But that was then and this is now, with the most obvious difference between the two periods being the increase in household indebtedness, both in nominal terms and as a proportion of household income.
Eight rate hikes would see variable mortgage rates lift back to 7% or higher, something even Edwards admits could “crimp” consumer spending due to increased household indebtedness.
There’s already plenty of concern over the outlook for household consumption given high debt levels, elevated underemployment and low incomes growth.
It’s highly debatable whether higher borrowing costs will help to reverse these trends, particularly in their infancy. Rather than contributing to an economic recovery such as the one the RBA currently foresees, which may well snuff it out.
No one truly knows just how sensitive household spending and business investment will be to a series of interest rate increases given its been six years since the last tightening cycle from the RBA concluded.
When the next tightening cycle eventually begins, or is even flagged, the RBA would want to be fairly certain that the economy can withstand tighter financial conditions caused by higher borrowing costs and Australian dollar.
It’s certain that when that moment comes, the RBA will want to be very confident that its forecasts are coming to fruition, as Edwards concluded with in his piece.
“The pace of tightening will anyway be governed by the strength of the economy,” he wrote.
“If household spending weakness, if the long expected firming of non-mining business investment is further delayed, if the Australian dollar strengthens, if employment growth is persistently weak, then the trajectory of rate rises will be less steep and the pace less rapid.”
And, if those outcomes do eventuate, the next tightening cycle may not even start, but rather continue the elongated easing cycle that began in 2011.
Time will tell as to whether the RBA or “glass-half-empty” crowd will be proven right.
You can read the full piece from Edwards here.