Interest rates might return to lower levels. The implications of “higher for longer” are profound.
When the Reserve Bank of Australia raised the cash rate target to 4.35 per cent last November, it took Australia’s policy rate to its highest nominal level since November 2011. Since then, attention has been fixed on when the central bank might start to ease monetary policy. But take a step back from that debate and another important question comes quickly into view. After the RBA has returned inflation to target, what then is in store for interest rates? Will it be a return to the low levels that characterised the pre-pandemic decade, or a new era in which rates will be “higher for longer”?
For an idea of the stakes involved, consider the history of the cash rate target this century. After starting the year 2000 at five per cent, it reached what (to date) has been its 21st-century peak in nominal terms in March 2008, at 7.25 per cent. But by September 2008, the onset of the GFC meant that policy was being eased again, and it had fallen to a low of three per cent by April 2009.
The RBA started to “normalise” policy with a sequence of rate hikes beginning in October 2009, but this time the rate peaked at just 4.75 per cent, in November 2010. And by November 2011, it was heading down once more, falling to a pre-pandemic low of just 0.75 per cent in October 2019.
Overall, between January 2000 and December 2008, the monthly average cash rate target was around 5.5 per cent. Then between January 2009 and December 2019, it fell to around 2.7 per cent.
The post-GFC, pre-pandemic world, was characterised by exceptionally low nominal policy rates where central bankers were worried about the challenges posed by a looming effective (or zero) lower bound.
This affected longer-term interest rates too. Take, for example, the nominal yield on the Australian government 10-year bond. In January 2000, this stood at a 21st-century high of more than seven per cent.
By August 2019, it had slumped to less than one per cent. And while between January 2000 and December 2008, the monthly average yield was around 5.7 per cent, that had fallen to 3.4 per cent between January 2009 and December 2019. (At the time of writing, the 10-year bond yield was back to around 4.1 per cent.)
Cause and effect
If, once the fight against inflation has been won, the Australian and world economies return to the pre-pandemic, low-interest-rate world, we would also be destined to return — for good or ill — to the accompanying environment for household and corporate balance sheets. This would have impacts on the way financial markets work, on financial stability, and on fiscal sustainability, as well as bring a return to old debates about unconventional monetary policy and the effective lower bound.
If we don’t return to that world, a new era of higher interest rates could have profound implications, such as:
Life would be tougher for those heavily indebted households and highly leveraged businesses that have become reliant on a world of low-cost financing
Financial markets would have to adapt, including business models such as private equity and venture capital that thrived in a low-rate world
Pressures on financial stability — such as those that afflicted parts of the US banking system in early 2023 — could return
Governments would have to manage higher debt service bills, placing additional strain on public finances and in some cases, raising questions over fiscal sustainability.
Economists often think about these differing scenarios in terms of the future of the neutral rate of interest, or r*. This is the real (that is, the nominal adjusted for inflation) interest rate consistent with the economy running at full employment and stable inflation.
The conventional view holds that r* is determined by deep, structural forces in the global and domestic economies that influence desired saving and investment rates. It reckons that over the past four decades or so before the pandemic, those structural forces moved in a way that led to an increased gap between desired saving and desired investment, generating a secular decline in r*. Most studies identify demographics and productivity growth as the key drivers here.
Population ageing and rising life expectancy, together with a slowdown in the rate of productivity growth leading in turn to slower economic growth, are together thought to have been the main forces behind the decline in r*. This was via a higher supply of savings and a lower demand for investment. Some economists have identified potential supporting roles for a shortage of safe assets, higher inequality, a rise in market power or a fall in the relative price of capital goods. According to this view, unless something substantial changes in terms of demographics (which seems unlikely) and/or in productivity trends (which is difficult to predict), then the baseline scenario is for a return to the pre-pandemic low r* world.
Could things turn out differently?
One alternative scenario is that productivity growth surprises on the upside. Currently, the strongest candidate here is the potential for an AI-led productivity boom.
Other possibilities are that a future of large and growing public sector debt and deficits due to rising spending on health and aged care running into political constraints on raising revenues will place upward pressure on interest rates. Or that new spending and investment pressures associated with the green energy transition and the need for higher defence spending in a riskier world will have a similar impact.
Which brings us to one final point. Should the baseline scenario prove to be wrong, and we end up in a world with a higher r*, the consequences will depend on what drove that shift. A world where higher rates are a product of faster productivity growth, for example, would be quite different to one that was the result of an unsustainable surge in unproductive government debt.
AICD chief economist Mark Thirlwell GAICD has focused on the international political economy at the Bank of England, JPMorgan, Austrade and Export Finance Australia.
This article first appeared under the headline 'Keeping It Real’ in the April 2024 issue of Company Director magazine.
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