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Could rates fall even further?

There’s no way the Reserve Bank of Australia will increase official interest rates while the economy remains in its current rut.

Australia’s economic fundamentals are quite problematic but this has not stopped some analysts from ramping up speculation about interest rate hikes, perhaps before the end of the year. More interesting, the money markets are pricing in higher interest rates over the next 12 to 18 months.

The reason why this is so misguided and misreads the current status of the economy is straight-forward. Growth, inflation and wages growth is low and the unemployment rate is high. It is worth taking a step back to see how the economy was performing the last time the RBA started an interest rate hiking cycle. That was back in October 2009, when the RBA increased the cash rate from 3.0 per cent to 3.25 per cent as the economy picked up steam as the impact of the global crisis faded.

In the six months prior to that hike in 2009, the unemployment rate hovered around 4.2 to 4.3 per cent and at the same time, annual wages growth was locked between 3 and 4 per cent.

Importantly, this ultra low unemployment rate and solid wages growth fed into underlying inflation which was above 3 per cent for two years. It was around 3.5 per cent as the first rate hike of that cycle was delivered.

At that time and with hindsight, it was quite obvious that higher interest rates and tighter monetary policy was needed to reign in inflation pressures which had been stubbornly high. In a nutshell, the economy was strong, with low unemployment, solid wage growth and inflation was uncomfortably high.

Fast forward to today. Let’s now look at the economic fundamentals the RBA will be confronted with as it considers what to do with interest rates.

Now, the unemployment rate is hovering around 5.6 to 5.7 per cent, a full 1.5 percentage points above the rate when the last interest rate tightening cycle started. Annual wages growth is currently at a record low, running at 1.9 per cent, almost half the rate in 2009. A critical point now is the underlying inflation rate. It has been below the bottom of the RBA target band for two years and last week, it was confirmed at 1.8 per cent to be about half the rate at the time of the start of the last interest rate tightening cycle.

For an interest rate hiking cycle to start, inflation needs to pick up to at least 2.5 per cent, while wages growth needs to lift to 3 per cent. This implies the unemployment rate needs to drop to 5 per cent or less and which on even the most optimistic forecasts, seems more a wish that a robust expectations of labour market conditions.

Until these sorts of readings for the economy come to pass, the RBA will not lift interest rates. Indeed, if there is any evidence of low wages growth and low inflation continuing near current levels, the RBA will cut interest rates to a fresh record low.
In the mean time, keep an eye on the data on wages, inflation and unemployment to work out when, and in what direction, the RBA will next move rates.