Inflation, Interest Rates - How Did We Get Here?

The outcome of the clash of views between bond and share markets will determine the economic outcomes in both the US and Australia. There are no quick and easy answers to this conflict so this week I am going to set out questions that we need to follow in coming months.

But first, some assumptions that both markets take as a given. In both Australia and the US large areas of the business community are enjoying a boom and this is boosting share markets. The US inflation rate is around 8.5 per cent and the Australian annual rate in the December quarter was about 5 per cent. Interest rates are set to rise.

Now for the questions:

How far will US interest rates rise and how quickly? 

The share market’s view is that while there might be a sharp rise in interest rates the rate rises will quickly bring inflation down, enabling the share market to continue to rise. The bond market thinks the rate rises will be around 3 per cent and if that is not sufficient to push the share market down they will rise further.

Bond traders think taming the out-of-control US inflation will be a tougher task than simply a short sharp blow. This is a crucial question, and no-one really knows the answer. For what it is worth, I am on the side of Goldman Sach’s Jamie Dimon who thinks the interest rate rise will be greater than the market expects, and he is alerting the US to a downturn that is more severe than the share market expects.

How far will interest rates rise in Australia?

The Commonwealth Bank of Australia says that our Reserve Bank will only increase rates by 1.25 per cent – far less than the likely rate increase in the US. The bond market thinks the increase will be at least 3 per cent and perhaps more. If the CBA is right, then shares in Australia should stay strong. But the bank warns that if interest rates were to rise by say 2.5 per cent, then there would be a severe economic downturn. The CBA is probably the best organisation in Australia to make that prediction because it is the largest home lending bank and it knows better than anyone else the level of exposure of homeowners to higher rates. 

If the bond market is right, then the Australian share market is very overpriced and house prices will fall by a sizable amount.

Can Australia sustain an interest rate increase substantially less than that of the US? 

Clearly the share market believes it can and I suspect the Reserve Bank has a similar view. If the US has a substantial interest rate rise that becomes a short sharp blow then I think it is possible to have a substantial difference between the US and Australian rates as the share market believes.

My view is that if US rates rise by say 3 per cent or more for an extended period (more than six months) the differential will cause substantial funds to leave Australia, will push the dollar down adding further to inflationary pressures. I don’t believe a major rate differential is sustainable for an extended period. We therefore depend on the US share market being right and the US bond market wrong.

How did we get into this mess? 

Very simply we had (and still have) an economic boom in large areas of the economy and we continued to stimulate via token interest rates and large deficits. Banks loaned too much money to people who were vulnerable to substantial increases in interest rates.

Is the US economy as vulnerable to higher interest rates as the CBA believes Australia is?

No. Our home borrowers have much greater debt than the US. Most US home loans have a rate that is stable for 30 years. That means that when rates rise it does not impact people’s mortgage commitments unless they need to sell their house and buy a new one. Higher interest rates do affect the value of US houses but have nothing like the impact than they do in Australia where the higher rates come straight out of the pocket of homeowners with mortgages. The people that are most vulnerable in Australia are those that bought a house in the last two or three years on very large mortgages.

How important is the Ukraine war? 

Clearly if there is an early peace agreement then it will not be that important but at this stage it looks as though we are looking at an extended conflict that will last many months or even years. That means that food and energy prices will stay high and may increase. It will also add a considerable degree of uncertainty to the world. The share market clearly believes that either the war will end early or is manageable. Note that the challenger for French President, Marine le Pen, wants to leave NATO and does not want to send weapons to Ukraine. If she wins that will change the balance of the game.

Does it matter who wins in the Australian election? 

I think an ALP win increases the danger of high inflation because it will inspire the unions, particularly the public service, to push for much higher wages. (Past ALP governments that have been in opposition for a long time often found it very difficult to oppose strong union demands.) 

If inflation stays high of course it puts enormous pressure on the Reserve Bank to increase rates more the CBA’s 1.25 per cent benchmark. The areas of the community that have not benefited from the boom – usually unskilled or semi-skilled labour – are very angry that their standard of living is falling, and therefore will put a lot of pressure on any new ALP government as well as a Coalition government. 

Will the lower rates of globalisation impact inflation?

China's vaccines have not worked as well as those in Western countries and so it is embracing a zero tolerance to COVID. This is lifting the costs of exports and affecting supply chains. It is also lowering Chinese growth. Companies around the world are making plans to increase sourcing of their goods and services to home base or at least in countries that are friendly.

As you can see, the above covers a wide set of scenarios. These great variations arise because we have a set of circumstances that we have not previously encountered. For what it is worth, the underlying inflation in both the US and Australia is going to put enormous pressure on the Reserve Bank to lift rates beyond the 1.25 per cent and therefore the Commonwealth Bank’s danger alert is in danger of being triggered.

I can’t be certain but I am increasing the cash in my portfolio to take heed of the unprecedented risks. But I am certainly not selling out of everything. Enterprises with pricing power will do well. Banks will try and maintain profits by squeezing depositors even more tightly. That will be a fascinating battle.