Just three weeks ago, Federal Reserve Chairman Michele Bullock said there would probably be no interest rate cuts in the next six months. But if there were any doubts about the direction of global interest rates, Federal Reserve Chairman Jerome Powell dispelled them on Saturday.
Before an audience of central bankers from around the world (including Deputy Governor of the Australian Reserve Bank, Andrew Hauser), Powell announced that the long-awaited interest rate cuts in the United States were imminent.
“It is time to adjust policy,” Powell said with a refreshing clarity that left no room for ambiguity.
“The direction is clear, and the timing and pace of rate cuts will depend on upcoming data, the evolving outlook and the allocation of risks.”
Interest rate cuts by the US Federal Reserve and other central banks will create almost irresistible pressure for the Australian Reserve Bank to follow suit.
My guess? Australians will likely see a rate cut as early as Melbourne Cup Day, Tuesday 5 November. Here’s why.
What happens in the US will also happen in Australia
At the next meeting of the Federal Reserve’s interest rate committee on September 17 and 18, the Fed will certainly cut the key interest rate for the first time since interest rate hikes began in 2022.
The United States would join the United Kingdom, China, Canada, New Zealand, Switzerland, Denmark, the European Union and a number of other countries in cutting interest rates – sometimes repeatedly – to support their economies.
The financial markets are expecting four interest rate cuts of a normal magnitude in the USA by the end of the year. Since the US Federal Reserve only has three meetings left this year, they are expecting at least one interest rate cut to be twice as high.
Australia and the USA are not so different
The US story, as Powell told it over the weekend, is also the Australian story.
Jim Lo Scalzo/AAP
In his speech, Powell described the rise and fall of inflation, explaining that inflation picked up when consumer spending rose sharply after the end of COVID restrictions.
The supply of goods could not initially keep up and consumers shifted their spending to services.
Then Russia invaded Ukraine, causing energy and food prices to rise and making high inflation a truly “global phenomenon.”
The reason for the decline in inflation from the end of 2022 was the normalization of goods, food and energy supplies, as well as a reluctance to spend on consumer goods following a series of aggressive interest rate hikes.
“Anchored” inflation expectations
The surprisingly subdued inflation expectations are responsible for the decline in inflation without (so far) major damage to employment in the USA.
If workers’ expectations of future inflation remain “anchored” at a low level and do not rise with actual inflation, they are also likely to make more modest wage demands and be more likely to keep their jobs.
But Powell said it was “far from certain that the inflation anchor would hold.”
In Australia – as in the US, UK, Canada and much of the rest of the world – inflation has been falling since the end of 2022. So, as in the US, our expectations have remained unchanged.
Australians expect further declines
Every month, the Melbourne Institute surveys Australians about their inflation expectations for the coming year. Expectations for two of these indicators are extremely low.
One of them is the so-called weighted mean, which ignores responses above 5% and below zero (on the grounds that they are unrealistic) and averages the rest.
This suggests that we should expect inflation to reach 2.6%: right in the middle of the Reserve Bank’s target range and by no means excessive.
Another measure is the unrounded inflation expectation. This excludes round numbers above 10, as it is assumed that someone who gives an answer of 15% is not serious, but someone who gives an answer of 14.9% is serious.
This figure suggests an inflation rate of 3.1%: almost exactly at the upper end of the bank’s target range of 2-3% and again no cause for concern.
Scope for interest rate cuts
According to Powell, since inflation is well anchored in the US, the US Federal Reserve can safely lower interest rates in order to support the labour market, which – like here in Australia – is beginning to weaken, albeit at a slower pace.
These are the parallels, and they are compelling. So the arguments for a rate cut in the US apply here too, although the timing is different. Australia started raising rates later than the US and will continue to do so later.
And there is another reason to believe that the impending cuts in the United States will likely quickly have an impact on the cuts here in the world.
The Australian dollar jumped after Powell’s speech. If Powell does indeed cut interest rates, the Australian dollar is likely to rise further.
This is because the cuts make the US a relatively less attractive place to store money, while Australia becomes a relatively more attractive place.
Cuts in one country affect cuts in another
The more the Australian dollar rises against the US dollar, the cheaper imports denominated in US dollars become – in other words, the lower Australian inflation becomes.
The same is true of other countries. Simply by lowering their own interest rates, the US and other countries will reduce inflation in Australia. The more they do this, the more Australian inflation will ease, making an ever stronger argument for our Reserve Bank to cut interest rates.
That’s why central banks tend to cut interest rates together (albeit with delays), which is why Australian financial markets on Monday were expecting one rate cut by Christmas and three in total by May.
Traders are not believing Reserve Bank of Australia Governor Michele Bullock when she said interest rate cuts were unlikely in the coming months. They believe that what happens abroad will happen here too.
