In recent times, much time and space has been spent wondering what central banks will do next with interest rates. While this constant speculation fills a gap, it can serve as a distraction for long-term investors.
Underpinning the obsession in media about the utterances and actions of central bankers – like the US Federal Reserve and the Reserve Bank of Australia (RBA) – are a number of assumptions.
Leading or following
The first of these is that interest rate decisions by central banks lead the market when it is often the other way around. The central banks tacitly admit that themselves when they say their future decisions are “data-dependent”.1
That phrase implies that their current view on the correct level and likely course of official interest rates may change as new information comes to light about inflation, economic growth, unemployment, and other variables.
In other words, the policymakers don’t have any more information or insight than the market itself. We are all working off the same signals, which means the central banks can be behind the market in coming to a conclusion about where rates should be set.
The Australian experience
Think back to November 2020, about eight months after the pandemic was declared. The RBA cut its official cash rate to a record low of 0.1%.
Given the significant uncertainty surrounding the path and economic impact of the coronavirus at that point, the bank’s governor Philip Lowe said the RBA was not expecting to increase the cash rate “for at least three years” or until inflation was sustainably within the bank’s 2-3% target range.2
But then things changed… and this is a very important point…..
Soon after the RBA announcement, there was a breakthrough in the development of vaccines. By 2021, the economic recovery was stronger than expected, and the RBA was forced to respond to this development.
By this time, inflation was starting to pick up again. In some advanced economies, headline rates were above 4%.3 But the view of the RBA governor, like those of other central bankers, was that this was likely to be a “transitory” phenomenon as increased demand was rising against pandemic-related supply constraints.4
“The latest data and forecasts do not warrant an increase in the cash rate in 2022,” Dr Lowe said in November 2021. “The economy and inflation would have to turn out very differently from our central scenario for the board to consider an increase in interest rates next year.”
But this is precisely what happened. In the March quarter of 2022, Australia’s annual inflation rate rose to 5.1%. This result, a 20-year high, exceeded market expectations and was fueled by the rising costs of building supplies, petrol and groceries.7
The RBA in May, armed with new information, appropriately and sensibly changed direction and raised the benchmark rate to 0.35% in the first policy tightening in more than a decade.8 Rates continued to rise from that point as inflation ratcheted higher.
Investors can take some comfort that the RBA and other central banks are not ‘asleep at the wheel’ and, by lifting, interest rates, are now appropriately winding back the stimulatory measures, which at the time seemed entirely the right thing to do in protecting the economy. It is only with the fortunate benefit of hindsight that the wind-back process could have occurred sooner to avoid the market shocks we have had to experience over the last year.
Acknowledging that these shocks have been quite unsettling, they should not be seen as unusual or unexpected, rather, they are a positive reflection of policymakers doing their job.
- ‘Data Dependent Monetary Policy in an Evolving Economy’, Jerome Powell, Federal Reserve, 8 Oct 2019.
- Statement by Philip Lowe, Monetary Policy Decision, 3 Nov 2020.
- ‘Euro Zone Inflation Hits 13-Year High Above 4%’, Europe News, 29 Oct 2021.
- ‘Recent Trends in Inflation’, RBA Governor Philip Lowe, Speech to ABE, 16 Nov 2021.
- ‘Consumer Price Index, Australia’, Australian Bureau of Statistics, 27 April 2022.
- ‘Australia’s Central Bank Hikes Interest Rates, Flags More to Come’, Reuters, 3 May 2022