Interest Rates in 2025: Cut or Comeback?
Key takeaways
According to the RBA’s forecast, inflation won’t hit the middle of its 2% to 3% target range until 2026. Many economists argue that it’s better to address inflation decisively now rather than let it become a persistent issue.
History tells us that inflation tends to reaccelerate 70% of the time after initially falling. If interest rates are cut to tackle inflation, we may see inflation reaccelerate in the coming years.
The data shows that higher inflation is driven by categories such as food, rent, healthcare, clothing and footwear, and insurance. Government spending has contributed significantly to the tight labour market and higher wage costs.
The challenge with using monetary policy to address inflation is that it’s a blunt tool, mainly affecting mortgage holders. Baby Boomers are less likely to be in debt.
I’m leaning towards the view that the RBA will start cutting interest rates within the next 6 to 12 months.
There has been a lot of commentary about interest rates and inflation over recent weeks.
Of course, no one really knows what will happen to inflation over the coming months, including the RBA.
Consequently, the timing of potential interest rate cuts is speculative.
Putting aside these predictions and rhetoric, I thought it would be useful to highlight some important factual observations.
The RBA’s actions and forecasts are at odds
According to the RBA’s forecast, inflation won’t hit the middle of its 2% to 3% target range until 2026.
Many economists argue that this pace is too slow and risks inflation becoming entrenched.
They believe it’s better to address inflation decisively now rather than let it become a persistent issue.
Persistently high inflation can harm consumers by continually increasing the cost of living.
This will force interest rates to stay higher for longer, potentially leading to an economic recession.
If the RBA believes its own forecast that current interest rate settings and expectations will be insufficient to bring inflation into the target range within an acceptable time frame then, technically, it should raise rates now.
The RBA has faced criticism for not hiking rates to the same level as other developed economies.
For instance, the US, UK, Europe, and Canada have all raised their cash rate above 5% to combat inflation, while Australia’s peak cash rate has only reached 4.35%.
This puts the RBA in a somewhat unique position.
Its reasoning might be that Australia has a higher proportion of variable-rate mortgages, making consumers more sensitive to interest rate changes compared to countries like the US, where most mortgages are fixed.
Time will tell if this strategy proves correct.
In short, the RBA’s forecast doesn’t appear to match its current actions.
Alternatively, perhaps it thinks sticky inflation is less of a risk.
Or maybe it’s trying to curtail the market from thinking that the battle against inflation has been won.
The market thinks rates will be cut soon
The chart below sets out the money market’s expectations for future changes to the RBA’s cash rate.
This yield curve indicates that the cash rate this time next year will be 3.46%, which is 0.89% lower than it is today.
In short, the money markets are betting that interest rates will fall by circa 1% in 2025.
Is the market always correct?
Back in 2021, RBA Governor, Philip Lowe stated that interest rates would very likely stay at the record low of 0.1% until at least 2024.
However, at the time, the money markets had a different view, pricing in interest rate hikes of 1.20% between late 2021 and mid-2023.
As it turned out, the market’s prediction was closer to reality than the RBA’s forecast.
By May 2023, the cash rate had risen to 3.85%, significantly higher than the 1.20% initially expected by the market at the end of 2021.
At the time, I found it puzzling that the RBA, as the rate setter, projected no hikes until 2024 while the market had a different outlook.
How could the market disagree with the person that was in control?
The key takeaway here is the importance of not disregarding the market’s signals.
The market isn’t a perfect predictor, but it’s a strong indicator that shouldn’t be ignored.
Furthermore, what central banks say, and forecast can no longer be relied upon as gospel.
What does history tell us?
Last year, I highlighted an analysis prepared by US firm, Research Affiliates which found that inflation tends to reaccelerate 70% of the time after initially falling.
Recently, fixed interest rate expert Christopher Joye shared insights from his team’s research in the Australian Financial Review.
They examined the past 75 years in the US and found that, on 16 occasions when the Federal Reserve significantly raised interest rates to tackle inflation, 15 of these instances either led to a recession or saw inflation reaccelerate.
Only once in that period did the Fed achieve a soft landing or “immaculate disinflation.”
Given this historical context, I think it is reasonable to expect that inflation might reaccelerate in the coming years.
If it does, any interest rate cuts we might see in 2025 could well be temporary.
What does the data tell us?
The latest CPI quarterly reading shows that higher inflation is driven by categories such as food, rent, healthcare, clothing and footwear, and insurance.
A significant portion of the persistent inflation is found in “non-tradable services,” including utilities, medical services, and insurance.
This is largely due to higher wage costs resulting from a tight labour market.
Government spending has contributed significantly to the tight labour market.
Christopher Joye points out that over the past year, the public sector has accounted for half of all job growth, despite employing only 31% of Australian workers.
Additionally, government spending has increased by over 25% in the past five years.
According to the AFR:
“Federal government spending hit an equal record 11.8% of GDP in the June quarter.
The only time federal government spending has been as large a share of the economy was in the early stages of the COVID-19 pandemic.”
Westpac’s economic team agrees with Joye in that government spending has contributed the most to inflation.
Policies such as not means testing the energy rebate and not delaying the Stage 3 tax cuts for another year certainly don’t help fight inflation.
The challenge with using monetary policy to address inflation is that it’s a blunt tool, mainly affecting mortgage holders.
Baby Boomers, who make up more than 27% of Australia’s adult population, are less likely to be in debt and often benefit from higher interest rates through increased investment returns.
While younger people have reduced their spending, CBA data shows that Baby Boomers have increased their spending on dining out by 7% and travel by 10%, for example.
How do you curtail inflation on non-discretionary inflation?
People with large mortgages and lower incomes are understandably feeling the pain from higher inflation and interest rates.
They can only cut back on spending so much, which makes their situation particularly challenging.
The government could assist the RBA by reducing its own spending.
In my view, Australia urgently needs comprehensive tax reform, a topic I’ve explored previously.
For instance, increasing the GST on luxury goods could help complement monetary policy effectiveness.
However, implementing such reforms often takes years or even decades – and a government with a long-term view, is hard to find.
Based on current data and historical trends, achieving a soft economic landing is going to be extremely difficult.
Even if we see some relief in interest rates over the coming year, it may be temporary.
On the other hand, a hard economic landing, while effective in cooling inflation, typically involves some economic pain, such as higher unemployment and slow economic growth.
Where to from here?
I’m leaning towards the view that the RBA will start cutting interest rates within the next 6 to 12 months, as suggested by the money markets.
The big uncertainty is whether the RBA will manage to achieve “immaculate disinflation” or if it will need to raise rates again in the future.
