Interest rates have been trending downwards in most major economies for the past three decades. Factors associated with driving falling interest rates have included declining long-term average economic growth rates; lower inflation; and at times imbalance between excessive private sector savings and investment. These three factors need to change direction if interest rates are to start trending upwards and the chances are near zero of that happening in the midst of the current deep recession caused by deliberately reducing economic activity to contain the Covid-19 infection rate.
One indication of how far away any possible turn towards an upward trend in interest rates may be came in the economic forecasts contained in the RBA’s quarterly Monetary Policy Statement released on Friday last week. The RBA’s GDP growth forecasts out to 2022 illustrate clearly that the growth path whether it be their base case forecast line, or a more optimistic or pessimistic forecast line all travel below the RBA’s base case forecast growth line published six months ago in February.
It is worth keeping in mind that when the RBA published its forecasts back in February with a higher forecast economic growth trajectory there was no likelihood of interest rates rising over the next year or so. Even then with no recession in prospect, but instead with annual GDP growth slowly building momentum to 3%+ in 2021, excess capacity would reduce only slowly and it would take more than a year for annual inflation to gain traction above 2% y-o-y. Based on the forecasts produced then it was unlikely that the RBA would start to raise interest rates before late-2021.
The latest August RBA economic forecasts make very different reading imbued with a huge negative economic shock from Covid-19 and a shock that is still evolving in a highly uncertain fashion with the second wave of infections. Essentially, the RBA’s latest base case forecasts have real GDP falling 6% y-o-y in both June and December 2020 before lifting 4% y-o-y in June 2021; 5% in December 2021; and 4% in both June and December 2022.
While the forecast annual increases in GDP look big in 2021 and 2022, they have been reduced from the +7% y-o-y June 2021; +6% December 2021; and +5% June 2022 forecasts produced by the RBA just 3 months ago in May. They also leave GDP well below where it would have stood early in 2022 on the RBA’s February forecasts.
Because of the lower August forecast recovery trajectory the unemployment rate stays higher for longer rising to 10% in December before slowly reducing to 7% by December 2022 (the unemployment rate was around 5% before the Covid 19 crisis hit and on the RBA’s February forecasts would have fallen to 4.5% by early 2022).
Much higher spare capacity in the labour market for much longer means an extended period of very low wages growth around 1% y-o-y and annual inflation barely above 1% y-o-y through to December 2022 on the RBA’s latest forecasts.
It is worth stressing the obvious at this point. The Covid-19 infection rate is proving very hard to contain and until the infection rate clearly reduces whether naturally or from better containment methods or an effective and widely available cure/vaccine is developed the risk remains of periods of restriction being imposed on social and economic activity. Covid-19 is still capable of disrupting economic forecasts and still mostly to the downside until a breakthrough dealing with it occurs.
As the RBA’s forecasts stand currently for GDP growth, unemployment and inflation very low interest rates are set to persist at least to the end of 2022 – that is the cash rate will be no higher than the current 0.25% and while there may be some near-term cyclical movement in longer-term bond yields movements they are likely to be minor with yields migrating back at least as low as where they stand currently through to end 2022.
Beyond the end of 2022, the limit of the RBA’s August published forecasts, there would seem to be a period extending through much of 2023 where GDP has not recovered to the point of using up excess capacity and generating higher inflation. However, the huge extent that Government’s around the world are turning towards spending and borrowing what it takes to cushion the negative impact of covid-19 restrictions on the income of households and businesses and to boost economic recovery beyond will lead eventually to stronger trend economic growth and a turn from trend disinflation to trend inflation.
The fiscal stimulus measures taken by governments around the world since the start of the Covid-19 crisis have risen to 10% of global GDP and are still climbing. Many Governments are turning towards considering longer-term spending to aid post-Covid-19 economic recovery. Government budget deficits and borrowings are ballooning including in Australia. Central banks are backstopping the ability of Governments to borrow more but aided during the recession by substantial private demand for bonds amid mostly rising household and business savings.
As GDP growth improves beyond the Covid-19 trough there is likely to be a lag before Government budget deficits and borrowings cap out and start to reduce. Government borrowings may become increasingly monetised by central banks in the early stages of economic recovery as private sector demand for bonds weakens. Increasingly monetised Government spending and borrowing adds to the fuel for a sharper rise in growth and inflation perhaps later in 2023 or 2024. When bond markets perceive a realistic possibility of a trend change from disinflation to inflation an abrupt rise in bond yields may occur.
Timing the change from the current low interest rate environment to a rising interest rate environment is hard to call. It is possible to say with some conviction that the current deep recession and its causes mean that low interest rates will persist through 2021 and 2022. It is also possible to say with some conviction that the move by Governments to fiscal stimulus on a scale not seen since World War II and backed by central bank monetary accommodation is a game-changer and one that will play out in a turn to higher trend inflation and interest rates and perhaps from as early as 2023.