Why higher interest rates are the new normal

Trying to guess where interest rates might move from month to month is a favourite pastime for many people in the financial markets (not to mention finance journalists).

And lately, we’ve all had plenty to speculate about. The surging oil price is making our inflation problem worse, prompting markets last week to price in up to three more Reserve Bank interest rate rises, which would push the cash rate above 5 per cent.

As dramatic as that would be, however, this column isn’t about what the RBA might do to interest rates this month or at the meeting after that. Rather, it’s about where rates are likely to gravitate in years ahead, and I’m afraid the recent news on that front is not what borrowers want to hear.

Economists and market experts lately have predicted rising global interest rates in the long term, and that’s likely to mean we end up with higher rates in Australia.

The causes are not only increasing inflation but also global “megatrends” as the rise of artificial intelligence, growing geopolitical conflict and decarbonisation.

What do these huge societal shifts mean for interest rates?

Quite a bit, according to the “neutral interest rate,” an economic concept that’s big in the world of central banking.

Raising interest rates is akin to hitting the economic brakes and cutting rates is like stepping on the accelerator, while the neutral rate is just that – one that neither stimulates nor slows the economy.

The dismal science of economics is known for being theoretical, but even here the concept of a neutral rate is fuzzy. It can’t be measured or observed, as with the unemployment rate can, and it changes over time.

Instead of measuring it, economists attempt to estimate where the neutral rate might be, and then use that in their analysis of whether interest rates should be more expansionary or contractionary.

It can get highly technical, but the key point is this: market economists believe the neutral rate has been steadily rising in recent years.

Commonwealth Bank’s senior economist Trent Saunders last week said CBA had lifted its estimate of the current neutral rate to 3.85 per cent, up from 3.7 per cent in July and 3.25 per cent last October.

These estimates have risen partly because our economy has been surprisingly resilient – it’s held up better than expected against three rate rises this year, for example.

There is a much bigger global story, as estimates of “neutral” interest rates have also risen around the world since the pandemic. This is where the huge trends of our era – such as AI, increased military spending and decarbonisation – come in.

Economists say that what ultimately sets global interest rates in the long term is the balance between savings and investment.

If you’ve got too much saving for the amount of investment, the returns savers can expect for lending their money will be lower (that is, they’ll have to accept a lower interest rate), and the converse if you have more investment than savings.

From the late 1990s to the early 2020s, there was a long-term decline in global interest rates, and a popular explanation for this was the “savings glut”. This basically said there was too much saving compared to investment opportunities, which drove down global rates.

Since the early 2020s, that trend appears to have stopped. There’s now huge demand for savings to finance the massive flows of money into artificial intelligence and data centres, the green energy transition and the lift in defence spending by governments.

“We expect investment demand to remain strong relative to global saving, placing continued upward pressure on neutral rates,” CBA’s Saunders says.

Westpac’s chief economist Luci Ellis, who has been talking about a higher “neutral rate” for two years, lists various reasons why we’re not going back to the low-rate world of the 2010s.

There’s been a societal shift toward greater expectation of government intervention in the economy – a trend that was solidified in the pandemic – which has meant higher spending by governments.

Raising interest rates is akin to hitting the economic brakes and cutting rates is like stepping on the accelerator, while the neutral rate is just that – one that neither stimulates nor slows the economy.

The growing rivalry between the US and China has prompted governments to spend more on defence and on supporting “strategic” industries, such as certain types of manufacturing. The likes of AI and the energy transition are soaking up more private sector investment.

Ellis’ view is that we’re not going back to the 2010s world of cheap money because it was an “aberration”.

So, that is why economists are convinced that the “neutral interest rate” will be higher than in the past.

What does all this mean for borrowers?

Put simply, it means the average level of interest rates in years to come is likely to be higher than it was in the low-interest rate world that preceded the COVID-19 pandemic.

There will still be cycles of interest rate moves, meaning the RBA will raise and cut rates in response to shorter-term “cyclical” changes in the economy.

But the “structural” or deep-seated trend will be towards higher interest rates than we’ve had in the past.

And when the RBA does eventually cut interest rates in this cycle – a move some expect next year – it won’t need to cut them by very much to take its foot off the brake and move into “neutral territory.”

In short, even when the RBA is satisfied it has inflation under control, we should not expect rates to come down by much. And unless there’s a crisis, they won’t return to the rock-bottom levels of last decade.

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