A high amount of \u201cexcess capacity\u201d was a big reason why interest rates were so low during the late 2010s. Unemployment was higher, typically above 5 per cent, unlike today, when it is 4.3 per cent. The RBA\u2019s key problem was that inflation was lower than its 2 to 3 per cent target range, so it tried to boost economic activity and inflation by using its main weapon \u2013 lowering the cash rate.<\/p>\n
From this level of already low rates, the pandemic forced central bankers around the world to go all out to prevent a complete meltdown. Rates tumbled even lower. Once the crisis receded and inflation reared its head, interest rates couldn\u2019t stay at emergency lows, so central banks reached for that weapon again. The RBA raised rates by 4 percentage points from 2022, before starting a cutting cycle at the start of this year.<\/p>\n
Fast-forward to today, and many think this cycle of rate cuts has ended after only three 0.25 percentage point reductions. Indeed, some economists are even talking about rate hikes. Why has the RBA been forced to quickly move from rate-cutting mode to potentially thinking about increases?<\/p>\n
The obvious reason is the recent jump in inflation. The bigger concern is that this has happened because the economy is hitting those dreaded \u201ccapacity constraints\u201d.<\/p>\n
As CBA chief economist Luke Yeaman said in a recent note, the economy is starting to pick up and there is less spare capacity than during previous economic cycles.<\/p>\n
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Rather than having unemployment above 5 per cent, as we did for much of the 2010s, it is now lower, at 4.3 per cent. It\u2019s good news that more people are in work, but it also means it is easier to hit those capacity constraints, causing inflation. It also means relatively small cuts in the cash rate can risk sparking inflation. \u201cThe RBA will need to remain \u2018on alert\u2019 to this risk, meaning interest rates can\u2019t fall as far, and rates will need to stay higher than in past cycles,\u201d Yeaman said.<\/p>\n
What is more, this worry about a lack of capacity isn\u2019t the only reason to think we are not going back to the cheap money era.<\/p>\n
A second, more global reason to think that that world is behind us is an economic concept called the \u201cneutral interest rate\u201d. This is essentially the interest rate level that neither stimulates nor slows economic growth.<\/p>\n
The \u201cneutral rate\u201d is a bit of a slippery concept: we don\u2019t know exactly what that number is. But the important point is that economists thought the neutral rate was falling for decades, and then more recently, it has been rising.<\/p>\n
Why might that be? In the long term, economists think global interest rates are determined by the balance between savings and investment: more saving will drag down rates, while more investment will push them up.<\/p>\n
One theory for the very low rates of the 2010s was the high amount of saving by an ageing population alongside a lack of investment, for example.<\/p>\n
More recently, however, economists have been pointing to big global forces that would drive up the \u201cneutral\u201d rate, such as rising investment.<\/p>\n
RBA assistant governor Christopher Kent in October said estimates of Australia\u2019s neutral rate had risen by about 1 percentage point.<\/p>\n
Kent said reasons for this increase in neutral rate estimates could include \u201crising global public debt, lower saving by retiring Baby Boomers, and increased public and private investment, including in the green energy transition.\u201d<\/p>\n
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Other mega-trends (not named by Kent) that are boosting investment around the world are the rush to build data centres, higher defence spending by governments and the increase in companies \u201con-shoring\u201d or expanding domestic production. If all that investment causes a change in the balance between saving and investment, it could nudge up interest rates further.<\/p>\n
To be fair, these are trends that play out over many years, so they\u2019re not going to affect short-term interest rate moves. But over the longer term, economists think our neutral rate has gone up, and that suggests the actual cash rate set by the RBA will also need to be higher to have the same impact.<\/p>\n
The bottom line for borrowers is this: unless there\u2019s some sort of economic emergency, don\u2019t expect interest rates to return to the rock-bottom levels of late last decade.<\/p>\n