What are normal interest rates that many central banks may aim to achieve over the next year or two now that global economic growth is reasonably well entrenched and needs no special support from super-low interest rates? Is this even a relevant question given that the world has adjusted to super-low interest rates and their removal could precipitate a sharp pullback especially in the more highly-leveraged parts such as the household sector in Australia?
Starting with the question of what is the normal official interest rate consistent with economic growth running close to potential growth, the answer is quite a relatively low rate these days because potential growth appears to be lower than it used to be. The potential growth rate is roughly the combination of population growth plus productivity. Australia’s population growth is around 1.4% y-o-y and trend growth in productivity is around 1.9% y-o-y placing potential growth around 3.3%. However, if the RBA’s cash rate were to be raised from 1.50% currently to 3.25%, most would view that as an activity-constraining rather than neutral interest rate setting.
Even at the current supposedly very accommodating 1.50% cash rate Australia’s unemployment rate moved up in February to 5.9% indicating increasing excess capacity in the labour market. If the Australian economy is not growing fast enough to reduce excess capacity in the labour market (and that is evident not just in the level of the unemployment rate, but also very high measures of under-employment and very low wages growth) there would seem to be no compelling reason for the RBA to consider start moving the cash rate towards a theoretically neutral or “normal” level.
One significant problem associated with keeping interest rates abnormally low for a very long period is that households and businesses start to behave as is if abnormally low interest rates are the new normal in their borrowing, spending and investment behavior. The protracted period of abnormally low interest rates has become a factor driving up asset price inflation. The boom in house prices in Melbourne and Sydney has been driven by several factors but one of the more important has been low borrowing interest rates allowing greater amounts to be borrowed by investors and owner-occupiers. Low interest rates have been capitalized in to high house prices and fast-rising house prices have attracted more to borrow to the limit while lenders chasing growth have found more ways to allow the limit to be stretched.
Household debt to disposable income has stretched out above 180%, historically high by Australian standards and by just about any other country’s standards too. At what point the household debt load becomes too heavy a burden and causes households to consolidate and start spending relatively less is difficult to assess. There is an increasing risk, however, that if households continue to borrow even more pushing house prices even higher that the eventual turn down could be very pronounced, possibly tipping the economy in to recession.
The choice facing the RBA is becoming more difficult. The general level of economic activity still implies that accommodating, well below normal interest rates are necessary. The borrowing activity of the household sector, especially relating to key parts of the housing market, suggests that interest rates are too low and are supporting activity that increase the likelihood of Australia suffering a true recession in the medium term. The RBA had hoped that non-interest related tightening of lending regulations might cap excessive borrowing by the household sector but the impact has been limited so far.
Increases in lending interest rates by Australian lenders unrelated to any movement in the RBA’s official cash rate are also showing little sign of denting the enthusiasm of the household sector to chase house prices higher. Increasingly it seems the RBA may need to reinforce the process of borrowing interest rates being less abnormally low even though such a move would be at odds with needs of the general economy. We still think it will be some months before the RBA considers a cash rate hike and then only if the housing boom fails to top out. Nevertheless, there is a risk that the RBA could hike the cash rate this year, a move that would take the market and households by surprise and be more effective as a result.
Interest rates may take many years to get back to anything approaching conventionally normal, but the first steps towards making rates less abnormal have already started in the United States and China and may extend to Australia too and more quickly than is widely believed likely.