Interest rate expectations
If you watch, read or listen to enough media, you’ll notice that much time and space is spent wondering what central banks will do next with benchmark interest rates. While this constant speculation fills a gap, it can serve as a distraction for long-term investors.
Many people believe that interest rate decisions made by central banks (such as the RBA) ‘lead’ the market. The reality is often the other way around. Central banks tacitly admit that themselves when they say their future decisions are “data-dependent”.
The phrase “data-dependent” implies that the central bank’s view on the correct level and likely course of official interest rates may change as new information comes to light about inflation, economic growth, unemployment and other variables.
In other words, the policymakers don’t have any more information or insight than the market itself. We are all working off the same signals, which means the central banks can be behind the market in coming to a conclusion about where rates should be set.
Think back to November 2020, about eight months after the pandemic was declared. The RBA cut its official cash rate to a record low of 0.1% – virtually zero – and lowered its target for three-year Australian government bonds to the same level.
Given the significant uncertainty surrounding the path and economic impact of the coronavirus at that point, the bank’s governor Philip Lowe said the RBA was not expecting to increase the cash rate “for at least three years” or until inflation was sustainably within the bank’s 2-3% target range.
But then things changed. Soon after the RBA announcement, there was a breakthrough on the development of vaccines. By 2021, the economic recovery was stronger than expected. And later that year and with market-set interest rates increasing, the central bank had to abandon its policy target for the three-year government bond. In other words, the market, responding to the same information, had essentially forced the RBA’s hand.
By this time, inflation was starting to pick up again as well. In some advanced economies, headline rates were above 4%. But the view of the RBA governor, like those of other central bankers, was that this was likely to be a “transitory” phenomenon as increased demand was running up against pandemic-related supply constraints.
“The latest data and forecasts do not warrant an increase in the cash rate in 2022,” Dr Lowe said in November 2021. “The economy and inflation would have to turn out very differently from our central scenario for the board to consider an increase in interest rates next year.”
But this is precisely what happened. In the March quarter of 2022, Australia’s annual inflation rate rose to 5.1%. This result, a 20-year high, exceeded market expectations and was fuelled by the rising costs of building supplies, petrol and groceries.
Having abandoned its attempt to control the yield curve six months before, the RBA in May now walked away from its cash rate forecasts as well and raised the benchmark rate to 0.35% in the first policy tightening in more than a decade. Rates continued to rise from that point as inflation ratcheted higher.
In making this decision, Governor Lowe described the central bank’s guidance that interest rates would not rise until 2024 as an “embarrassing” error and announced an official review into how the bank had got its forecasts so wrong.
The lesson for investors here is that central banks have no more information than the market itself and are just as “data-dependent” as everyone else.