·       “All eyes on the Fed”

Highlights from the September Quarter 2023

·        RBA keeps rates on hold

·        Chinese economy struggles with transition

·        US congress faces budget crisis 

Interest rate expectations

When the current rate hike cycle began in the US, the world had witnessed a decade- and-a-half of easy money policies and consensus had started to shift on where neutral rates were likely to settle. Years of ultra low interest rates had little impact on inflation and so it seemed that loose monetary policy could continue, perhaps, indefinitely.

Then covid hit, supply chains fractured and war broke out. This, at the same time when consumers had been locked away and ready to spend, meant that rising consumer prices were on their way. Central bankers assessed economic conditions poorly. The Fed assumed that inflation would be temporary or transitionary, as supply shortages and excess demand would soon dissipate. The RBA also misread the situation, infamously predicting that interest rates would stay put for another year or so. Hindsight bias... sure; but definitely some confirmation bias exhibited by those tasked with adjusting the monetary levers.

Inflation: Australia vs US

Source: TradingEconomics   

Inflation is currently at persistently high levels. Yes, price increases have come off from their highs (especially in the US, which has seen a drop of year-on-year inflation from 9% to below 4%), but cash register shock is still an everyday affair for most. Spending and demand is not doing quick enough, so companies will still keep on passing on add much of their supply prices increases as possible.

The main tool that central authorities have in this regard is interest rate settings. This works well in Australia due to the high level of mortgage indebtedness (compared to other countries), which means that interest rates changes can affect disposable incomes and spending quite quickly. Thus, rates have jumped 4% in very quick time.

Cash rates: Australia vs US

Source: TradingEconomics   

The US has seen an even greater jump from zero, with rates heading up towards 6%. With a much lower proportion of households on variable rate mortgages, the rate hikes by the Fed have a much lower impact on demand,

Apart from dampening spending, hiking interest rates also increases the cost of capital for business, making investment a difficult proposition. This can effect future production, meaning that current supply issues might be extended for longer.

So central bankers have plenty to think about in trying to navigate a 'soft landing', where business investment and hiring doesn't fall off a cliff whilst attempts are made to put the inflation 'genie' back in the bottle. And to help gauge the thinking of the central banks, most now look to release timely and informative forward guidance.

Fed Dot Plot

Source: TradingEconomics   

In the US, Fed board members deliver some of their interest rate guidance via the 'dot plot'. This is a visual mechanism in which the board is able to provide their expectations on where cash rates will be at various points in the future. This can help investors, business, and mortgagees understand likely paths forward.

The above chart shows that the Fed board members are expecting cash rates to drop from their current 15-year high, back towards a more ‘neutral’ position. The median expectation for 2024 is 5%, which is expected to drop to 4% in 2025. The long-term median of 2.5% seems to suggest that US central bankers have this rate in mind as a long-term benchmark. 

In Australia, the RBA has recently gotten in trouble for their level of communication to the public. This was evident in the surprise that many mortgage holders felt as loan repayments jumped in a short period of time. Whilst no-one expects central bankers to get it exactly right, forward guidance to the market and the public, can help with the various decisions that are impacted by interest rate levels.

Things to watch out for:

·        Debt ceiling and budget clashes likely to cause ongoing headaches for US

·        High interest rates and overindebtedness to push countries towards a recession 

The end of the current rate hike cycle

Whilst the market has not appreciated threats of government shutdown and temporary treasury defaults, most are are concerned about whether interest rates will stay higher for longer. With a tight labour market and demand remaining high, interest rates may still have a little easy to go before cuts are likely to be entertained.