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15 Jul 2021

Stimulus is being scaled back but don't expect interest rates to rise

By Josh Williamson, head of economics Australia and New Zealand for Citi The Reserve Bank of Australia has gone out of its way to reinforce its view interest rates will remain on hold, but it acknowledges the recovery is advanced, and change will come

The debate on the future direction of interest rates is heating up with some economists recently predicting a rate rise next year, and even for rates to rise from an historical low of 0.1 per cent currently to 1.25 per cent by late 2023.

Certainly, rising property prices, falling unemployment, an expanding economy and red-hot mineral prices suggest economically, things are going well in Australia. To a large extent they are, but there are underlying conditions that push against the notion of a rate rise.

In a briefing to the press and market economists following the July Policy Board Meeting, RBA Governor Philip Lowe reiterated the need to keep rates low, primarily because wages growth remains subdued.

Lowe said: “for inflation to be sustainably in the 2 to 3 per cent range, it is likely that wages growth will need to exceed 3 per cent”. Furthermore, “we expect it will be a few years still before it increases back above 3 per cent.”

These comments strongly suggest that cash rate increases are unlikely any time soon, and we would rally against calls for cash rate increases next year based on this advice, with the Governor adding “We’re certainly not looking at rate increases in 2022”.

The holistic picture - wages, inflation, unemployment

But inflation is not the only driver of wage growth. The RBA considers for wages growth to top 3 per cent and grow meaningfully will also require the unemployment rate to be close to 4 per cent. It fell from 5.5 per cent in April to 5.1 per cent in May, while inflation came in at 1.1 per cent.

This suggests that the RBA believes the non-accelerating inflation rate of unemployment (NAIRU) – which is the base level of unemployment in an economy that will not push up inflation - is down at that 4 per cent level.

The RBA has also indicated the degree of monetary accommodation needs to be higher in Australia compared to other countries because before the pandemic, wages and inflation in Australia were relatively lower.

Monetary accommodation has been used by the RBA to nurse the economy through the pandemic crisis. It has included buying government bonds to free up investment funds for other activities, providing cheap debt facilities to banks to ensure cheap cost of funds, maintaining ultra low interest rates to relieve the burden on business and households, and a range of other measures.

Ultra low interest rates also make vanilla investments like term deposits and savings accounts unfavourable, as the return may not even match the erosion from tax and inflation. This pushes even mum and dad investors up the risk scale as they seek to maintain their funds, or alternatively they spend the money as returns are so low. This is something the RBA wants as it is economically stimulatory.

Another impact of the RBA rising rates early is that it makes the Australian economy attractive to offshore investors, as the rate of return available here would be higher than other jurisdictions with lower interest rates.

While that is often desirable it also has other consequences, like putting upward pressure on the Australian dollar. A strong dollar reduces the income of exporters, as they mostly deal in US dollars for their offshore sales. It also makes imports cheaper, diverting attention from local products.

To maintain control of the economic narrative, we believe it suggests the RBA is unlikely to lift rates until other central banks begin a more concrete tightening cycle. Our US economics team believes the US Federal Reserve’s first rate hike will be in December 2022.

This does not mean the RBA is maintaining all it’s controls. The RBA has already said it will begin scaling back its asset (bond) purchases in November. This was largely driven by the better-than-expected economic outcomes in the first half of the year.

Moreover, Lowe reiterated that the step-down in purchases “does not represent a withdrawal of support by the RBA”.

The cash rate and the yield target come as a “package”, but for how long?

An indicator of when the RBA signals a rate cut is coming will likely come via the yield target.

The RBA has used its bond purchasing activities to maintain the three-year government bond at a rate it considers desirable to support its broader economic stimulus package. Currently it means purchasing the April 2024 three-year government bond to maintain its yield at 0.25 per cent.

If you consider this like other measures like cheap funding to banks, it is all designed to push investment funds up the yield curve into more riskier assets, as it provides greater stimulatory inputs to the broader economy.

Currently the RBA considers the cash rate and the yield target inextricably linked. However, if it wants to move early on a rate rise it could remove this “package” and separate the yield target and cash rate. For example, if it signals its intention to stop purchasing the April 2024 bond it would indicate it believes the conditions can be met for the cash rate to rise earlier. Such a move would align with our view that a rate rise is more likely in the third quarter of 2023, rather than holding back until 2024.

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