After enduring a tough year financially, many Australians will no doubt be wondering how long interest rates will stay high and when households can expect some relief in the form of rate cuts.
There have been clear signs in recent weeks that the Reserve Bank’s 18-month monetary tightening cycle, which took the cash rate from a record low of .1% to 4.35% as of December, is beginning to weigh heavily on consumers and businesses. Data in December showed business confidence in Australia has plunged to an 11-year low while consumer sentiment is also in pessimistic territory, largely due to rising borrowing costs and elevated prices.
The impact was also apparent in the surprisingly sharp slow down of the Australian economy during the September quarter, when gross domestic product (GDP) advanced just 0.2%. Our usually hot property market has also stalled amid worsening affordability that has pushed buyers to the sidelines.
Why Are Interest Rates So High?
The Reserve Bank has cited Australia’s persistently high inflation as the number-one reason behind its repeated interest rate increases that may yet tilt the economy into a recession.
The consumer price index (CPI) peaked at 7.8% in December 2022, and despite the force of the numerous interest rate hikes by the central bank, has been slow to wind down. Inflation continued to be hotter-than-expected at 5.4% in the September quarter. That is a long way off from the RBA’s targeted band of 2% to 3% inflation.
The sluggish decline forced the central bank to resume rate hikes in November after a four-month pause, taking its cash rate to a 12-year high of 4.35%.
Like its counterparts across the world, the RBA is wary of inflation expectations becoming entrenched, which would require much higher interest rates and much higher levels of unemployment to reduce.
High inflation tends to distort the economy because it results in people putting off a lot of economic activity to protect themselves from it, resulting in a waste of economic resources. It can also adversely affect productivity, reduce the value of savings, hurt household budgets, and make it harder for businesses to plan and invest.
Will They Rise Further?
Could interest rates go even higher? Most economists, and even the RBA, are not really sure. They say the answer would be determined by economic data and the evolving risks for the economy.
Callam Pickering, Asia-Pacific economist at jobs listing site Indeed, says further rate hikes are certainly possible: depending on whether service sector inflation (housing, transport, restaurant, travel, etc.) shows meaningful signs of moderation. That could be determined by December quarter inflation data that will be released at the end of January.
“My personal view is that the recent data flow—including monthly inflation, labour market and GDP—suggests that monetary policy is beginning to have the intended impact on the Australian economy,” he said. “The slowdown in household spending suggests that another rate hike has become less likely.”
ANZ Bank senior economist Adelaide Timbrell holds a similar view. She says while the possibility is active, recent data including the higher unemployment rate in November means the chance of another rate hike is less likely.
“Our central scenario is that the Reserve Bank is done and will not need to lift rates further,” she said.
“But if there are surprises on the upside for inflation versus the RBA’s own inflation path, or if the risks grow for inflation to not reach the target (band) by end-2025, that could change the bank’s most likely move to a further hike,” she warned.
How Are Households Coping?
RBA Governor Michele Bullock this month acknowledged that 2023 had been “a hard year” for Australians grappling with rising interest rates and inflation.
The central bank’s 13 interest rate increases since May 2022 have resulted in some households entering mortgage stress territory. Overall consumption is up just 0.4% in the last 12 months and is actually down 2% on a per capita basis. Household spending has been sustained only by a reduction in the household savings rate, which has offset a fall in household income.
“At the current cash rate, things will be challenging for Australian households in 2024 and household consumption is the biggest downside risk for the Australian economy next year,” Pickering warns.
ANZ’s Timbrell also expects things to get worse in the short term, before the situation returns to normal.
“We’re expecting the economy to be slowing through the first half of 2024 and then re-accelerating from there. Households in particular will see consumption fall in the near term, before regaining as lower inflation and the end of rate rises helps real household incomes adjust upward.”
When Will Interest Rates Come Down?
While there is still talk about another rate hike, some market watchers are already betting on the possibility of rate cuts next year.
Pickering says this discussion is likely to be driven by concerns around falling household spending, but would still require solid evidence for the RBA to be convinced that inflation is heading back to its 2% to 3% target band.
“For rate cuts, we’d need to see inflation under-shoot, or a growing belief that the economic outlook is perilous,” he said. “My view is the household sector represents a considerable downside risk to the economic outlook and will trigger increased discussion about rate cuts during the second half of next year.”
ANZ’s Timbrell says specific factors that the central bank would need to consider to embark on rate cuts would be a convincing slowdown of inflation, where getting comfortably in the target band in 2025 looks likely, and also enough cooling in the labour market.
“So more unemployment and less inflation, which shows that the economy has cooled sufficiently to allow an unwinding of restrictive policy,” she said.
Influence of US Federal Reserve on Rates
In a surprising move, the US Federal Reserve last week signalled the end of US monetary policy tightening and said lower borrowing costs were likely in 2024. Economists are not convinced this pivot would be enough to force Australia’s central bank to follow with its own rate cuts.
Pickering says the RBA closely watches global developments and if the Federal Reserve or ECB were forced to ease, that could impact its thinking. But the actual decision to cut rates would be driven primarily by domestic factors.
“Merely normalising monetary policy abroad would not be enough to trigger a shift in RBA thinking and, in fact, the RBA may even welcome that given the likely impact it would have on the Australian dollar,” he said.
Timbrell agrees with that view, saying the Fed’s potential easing could make it easier for the Reserve Bank to start cutting rates in late 2024, but these short-term developments will pale in comparison to the impact of homegrown factors on Australia’s interest rate trajectory.
“A lot of our inflation problem, and a lot of the issues that the RBA are looking at now, are more domestic. Apart from wage growth, the Australian labour market and how much Australian households are spending, the financial stability of the Australian household sector and of course, Australian inflation,” she said.
AMP economist Shane Oliver also believes that just as Australia’s inflation and interest rate hikes lagged the pickup in US inflation and interest rates by a few months, it’s likely to be the same on the way down. “The fact that the US is moving towards rate cuts suggests that the RBA will likely do the same with a lag,” he said.
How Far Could Rates Fall in 2024?
When interest rates do start to come down, economists are convinced the decline will be gradual and nowhere close to the lows seen prior to May 2022. What they are unable to agree on, though, is the extent of the possible rate cuts next year.
Indeed’s Pickering expects increased chatter around easing will emerge over the second half of next year as households continue to struggle. However, he doesn’t anticipate any rate cut next year “unless conditions in the household sector deteriorate so much that a recession becomes a likely scenario”.
ANZ’s Timbrell is expecting rates to remain largely stable at the current 4.35% through 2024, followed by a single 25 basis points rate cut in the fourth quarter.
AMP’s Oliver is far more optimistic. He expects the RBA will start cutting rates by the middle of next year, taking the cash rate down to 3.6% by the end of 2024.