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In 2023, central banks worldwide are continuing to increase interest rates because inflation still remains higher than inflation targets – i.e. a 2-3% target in Australia and 2% targets in the US and UK. The RBA lifted the cash rate to 3.35% on 7 February and, on 1 February, the Federal Reserve announced a Federal Funds rate increase of 25 basis points to the 4.5% to 4.75% range (Figure 1). And more rate rises are expected.

In Australia, Commonwealth Bank and Westpac economists are expecting two more quarter-percent rate rises, taking the cash rate to 3.85% by mid-2023. ANZ and NAB economists are expecting three more increases, taking the cash rate to 4.10%. In contrast, one of Australia’s best economic forecasters, Morgans Chief Economist Michael Knox forecasts a cash rate of 4.85% by August 2023. Knox argues that the US budget deficit is continuing to bolster global demand, and that the RBA pays a lot of attention to the state of the labour market. Given unemployment remains low, at 3.7% in February, the economy needs to slow down more before the RBA would end its monetary policy tightening. Incidentally, while the unemployment rate did increase from 3.5% to 3.7% in January, this may have been related to an abnormal number of people waiting to start new jobs in February, as reported by the Australian Financial Review. 

Everything depends on how the economy reacts to the monetary policy tightening, and how quickly inflation comes down. In Australia, the last yearly inflation figure was 7.8% for December quarter 2022, which was higher than the US’s but lower than UK’s inflation figures (Figure 2). It is unclear at the moment whether the RBA has tamed inflation. There are tentative signs of some slowdown in household spending as interest rate increases affect households and of the labour market becoming less tight, but more data over the next few months are required to be sure. Things could change rapidly over the rest of 2023, as households roll off fixed rate home loans taken out at very low rates in 2020 and 2021. The RBA has estimated around 800,000 households could be affected by the so-called fixed rate mortgage cliff. Prominent commentators are concerned about what this means for household spending and the Australian economy. For a good summary of the risks, check out Coolabah Capital Chief Investment Officer Christopher Joye’s commentary on the Livewire Markets podcast in early February: The RBA got it wrong, now it will crush everything.

In the US, inflationary pressures did appear to be residing, with the inflation rate falling from 7.1% in November to 6.5% in December 2022, but it only fell to 6.4% in January, defying market expectations of a fall to 6.2% (Figure 2). The Financial Times has reported “the central bank’s battle against high inflation appears far from over.” Given the average tightening cycle of the US Fed is just under two years, and the Fed only started increasing rates last March, it may still have some way to go. Goldman Sachs and Bank of America are expecting three more Federal Funds rate increases this year, bringing the target rate to 5.25% to 5.5%, according to Reuters.

Where will interest rates ultimately settle after central banks have got inflation under control? Unfortunately, it is not possible to provide a rule of thumb regarding a normal level of interest rates because it depends on a whole range of economic and even psychological factors. Prior to the pandemic there was a strong argument that the world had entered an era of permanently lower interest rates because of lower prospects for economic growth. Former US Treasury Secretary Larry Summers referred to this as Secular Stagnation. So much depends on the prospects for global economic growth, which will be affected not just by economic factors but geopolitical and demographic factors, with some commentators concerned about the implications of China’s falling population. 

For a discussion of what’s been happening with interest rates in recent years and what levels of interest rates have been common historically, check out of episode 173 of the Economics Explored podcast on the normalisation of interest rates, in which Adept Economics Director and Research Economist Arturo Espinoza discuss these issues. You can listen to the conversation using the embedded player or via Google Podcasts, Apple Podcasts, Spotify and Stitcher. 

Published on 20 February 2023. Please get in touch with any comments or questions via contact@adepteconomics.com.au or by calling us on 1300 169 870.