The Risk of Higher Rates the RBA’s Overlooking

In a recent wire, I substantiated my doubts that central banks in Australia and the U.S. will be able to return the genie of consumer price inflation to its bottle (their targets) as easily or quickly as many people suppose (see Farewell low “inflation” and interest rates? 20 February; see also Why inflation is and will remain high, 15 August 2022). The closures and failures of American banks haven’t lessened these doubts; and last week’s release of consumer price data in the U.S. have strengthened them.

As a result, Leithner & Company continues to incorporate into its plans the risk that consumer price inflation becomes stuck above central banks’ targets, and therefore that their policy rates of interest eventually rise significantly higher, remain higher longer and recede more slowly than many people currently believe. These things, if they occur, will certainly surprise and perhaps even shock the crowd. The implications for the prices of stocks, bonds and real estate therefore aren’t pretty.

In this wire, I trace the risk that Australian rates remain higher for longer to one of its antecedents. I show that Australians’ most basic assumption about the RBA simply isn’t true: it doesn’t – and in a globally-integrated economy it can’t – determine this country’s monetary policy. Imperfectly and with variable lags, it must ultimately follow the U.S. Federal Reserve’s lead.

Consequently, the RBA’s extensive analyses of domestic economic conditions in its publications, its regular elaborations in speeches, etc., and economists’ and journalists’ obsessive parsing of these entrails – as well as Jim Chalmers’ irksome mantra “the independent RBA” – are mostly distractions. Yet they thereby serve two crucial – to the RBA – purposes: they (1) highlight the relatively unimportant fact that it’s organisationally separate from the Commonwealth Treasury and (2) obscure the crucial reality that it can’t indefinitely act autonomously of the Fed. 

Act I: “Higher for Longer”

It now seems long ago: at its meeting on 7 March, the RBA lifted its target for the Interbank Overnight Cash Rate (“OCR”) by 25 basis points to 3.60%. Its press release stated that the RBA took this decision because it “is seeking to return (consumer price) inflation to the 2-3% target range while keeping the economy on an even keel, but the path to achieving a soft landing (that is, averting a recession) remains a narrow one.”

Further, “the Board expects that further tightening of monetary policy will be needed to ensure that inflation returns to target and that this period of high inflation is only temporary. In assessing when and how much further interest rates need to increase, the Board will be paying close attention to developments in the global economy, trends in household spending and the outlook for inflation and the labour market. The Board remains resolute in its determination to return inflation to target and will do what is necessary (nobody ever asks it: does that mean that it’ll deliberately trigger a recession?) to achieve that.”

Also on 7 March, in his Semiannual Monetary Policy Report to the Congress, the Chairman of the Fed’s Board of Governors, Jerome Powell, stated: “Although (consumer price) inflation has been moderating in recent months, the process of getting (it) back down to 2% has a long way to go and is likely to be bumpy ... The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated. If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes. Restoring price stability will likely require that we maintain a restrictive stance of monetary policy for some time.”

“Our overarching focus,” Powell concluded, “is ... to bring inflation back down to our 2% goal and to keep longer-term inflation expectations well anchored. Restoring price stability is essential to set the stage for achieving maximum employment and stable prices over the longer run. The historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”

Commentators in Australia and markets in the U.S. responded very differently to their respective central banks’ decisions. In Australia, a key theme was (in the words of a columnist in The Australian on 9 March) “the prospect of a ‘pause’ in the wave of rate rises over the past year.” 

The RBA’s Governor fanned this speculation. “An end to back-to-back rate rises could come as soon as next month, after ... Philip Lowe said ‘we are close to the point where it will be appropriate to pause interest rate increases.’“ Subject to four releases of domestic data, “at some point it’s going to be appropriate to sit still and assess the collective effects of (what the RBA has done) ... If collectively (these data) suggest that the right thing is to pause, then we’ll do that. But if they suggest that we need to (continue to increase the OCR’s target), then we will do that.’”

American markets’ reaction to Powell’s statement was starkly different. “A more hawkish than expected Jay Powell sparked chaos across markets that had desperately hoped for some dovish (signs),” Zero Hedge reported on 8 March. “The market’s expectation for the Fed’s terminal rate (that is, the longer-term target funds rate at which consumer price inflation is within the Fed’s target and full employment is achieved) soared to 5.65% ... For context, the market is pricing an additional 105 basis points of tightening in the Fed funds rate.” “We would be foolhardy to expect we can’t reach 6% ..., and clearly that has an impact on asset markets across the globe,” a strategist at Rabobank told Bloomberg Television on 9 March.

Using data from CME FedWatch, Figure 1 plots the mean federal funds rate imputed in interest rate futures markets in January, February and 1-7 March for contracts expiring on 31 March, 30 June, 30 September and 31 December.

Figure 1: Implied Federal Funds Rates, Q1-Q4 2023

From January, through February to the first week of March (that is, before the eruption of the banking crisis in the U.S. on 8 March), the imputed funds rate at the end of each quarter rose. Indeed, each successive quarter’s “staircase” becomes steeper: that’s the “higher” part of “higher for longer.” In January, for example, futures markets implied that the funds rate on 31 March would be 4.86%; in February, this estimate increased to 4.90%; and on 1-7 March it rose further to 4.97%.

In January, traders expected that the funds rate would peak in June (at 4.97%) and then fall to 4.82% in September and 4.51% in December. By 1-7 March they expected that rates will peak later (in September) at a higher level (5.56%) and will remain higher for longer (5.44% in December).

Act II: “Higher no Longer”

On 8 March, the California-based and crypto-friendly Silvergate Bank announced that it intends to unwind and liquidate; on the 10^th, the tech startup-friendly Silicon Valley Bank (America’s 16^th-largest) failed; on the 12^th, regulators closed the New York-based Signature Bank; on the 14^th, Credit Suisse (founded in 1856, and not long ago one the world’s top-20 banks) began to totter – and on the 15^th its shares plunged to a record low (since 2015 they’ve lost ca. 95% of their value) and it received a bailout from the Swiss central bank. Over the weekend of 18-19 March, multiple reports emerged that UBS will receive a “backstop” from the central bank to acquire Credit Suisse.

Finally, on 16 March and via an unsecured $US30 injection of deposits, America’s largest banks including Bank of America, BNY-Mellon, Citigroup, Goldman, JPMorgan Chase, Morgan Stanley and Wells Fargo rescued First Republic Bank, a regional lender based in San Francisco, whose shares had collapsed by half and bonds been downgraded to “junk” over the preceding couple of days. It availed nothing: on the 17^th its stock collapsed another 50%.

Symbolically, the most recent of these events occurred on the 15^th anniversary of the Fed-backed rescue of Bear Stearns; objectively, SVB’s failure is the second-largest (measured by its assets but unadjusted by CPI) in U.S. history; collectively, this is by far the biggest and most significant cluster of bank failures and bailouts since the Global Financial Crisis.

An Amusing – and Revealing – Aside

During the past week, some people have asserted that the Trump-era deregulation of banks has helped to trigger – indeed, perhaps has even caused – the current crisis. Yet they’ve attributed no blame to a key proponent of those reforms nor to the position he holds today.

Since 2015, Signature Bank’s board of directors has included none other than Barney Frank – the very man whose namesake Dodd-Frank Act imposed additional regulations upon banks in the wake of the GFC. On 16 March he told The Financial Times that he’s “chagrined” about Signature’s closing “because obviously people will say, ‘Oh, hey mister, you told everybody else how to run a bank and the bank you were helping (to) run (has) failed.’”

When he left Congress in 2013, Frank rightly – indeed, honourably – declined a pension. “Having retired, not having a pension by my choice, not wanting to be a lobbyist for reasons personal, I (needed) to make some money. I do it in part by writing. But I also do it by joining boards. Logically, I’m asked to join boards on subjects with which I was identified.”

As a Congressman, Frank lambasted political staffers who became lobbyists for banks. Yet after leaving Congress, he joined Signature’s board!

It strains credulity to deny that he’s acted as its lobbyist: after joining its board, he argued publicly that Dodd-Frank’s $50 billion threshold for imposing tougher regulatory measures was too low. Congress duly raised the lower bound to $250 billion in 2018 – and thereby exempted Signature and most other regional banks from these extra regulations. Frank told The New Yorker (“Why Barney Frank Went to Work for Signature Bank,” 15 March) that he changed his view well before joining Signature. If so, did he change his view diametrically in order to become an attractive candidate for a regional bank’s board?

We Return to Our Normal Program ...  

Since 8 March, two fears have flared: first, further, more widespread and bigger bank closures and failures (contagion) will occur, crushing banks – and the owners of their bonds and stocks; and second, the negative impact of this contagion will extend across the economy (recession).

Given these fears, recent events triggered a stampede out of regional banks and into U.S. government securities. Indeed, the two-year Treasury’s price skyrocketed more than during any two-day period since 1987, and to a yield below the federal funds rate.

Figure 2: Implied Federal Funds Rates, Q1-Q4 2023

Figure 2 plots the mean federal funds rate at the end of each quarter imputed from prices in futures markets in February, 1-7 March (before the ructions erupted), and 8-17 March (since they commenced).

Since 7 March, markets have imputed an ever lower funds rate at the end of each quarter. The impact on 31 March is minor: it averaged 4.90% in February, 4.97% on 1-7 March and 4.87% on 8-17 March.

On 17 March, markets expected (the odds are ca. 62%) that later this week the Fed will keep its funds rate at the current 4.5-4.75%. The odds that it will raise to 4.75-5.0% are just 38%. On 7 March, the imputed probability of a “hold” was 0%, of a rise of 25 basis points was 21% and of a rise of 50 basis points was 79%.

On 1-7 March, futures markets anticipated that the funds rate would peak in September and then decrease slightly (to 5.44%) in December; on 8-17 March, they expected that rates will peak in June (indeed, on 17 March they implied that rates have peaked) and then fall materially thereafter.

The most recent expectations imply that the Fed will cut ca. 25 basis points by the end of June, by an additional 25 by the end of September and by an another 50 by the end of December. The rise later this week, if it occurs, which now seems unlikely, will thus be the last – and then come ca. 100 basis points of cuts during the remainder of the year. In other words, the expectation is now “higher no longer.”

Act III: Now What?

Which risk – above-target consumer price inflation (which necessitates even higher policy rates) or contagion from bank failures (which feeds the clamour for pauses or even cuts of rates) has worse long-term consequences? Consumer price inflation eased in February, The Wall Street Journal reported on 14 March, “but remained stubbornly high, presenting a challenge for the Federal Reserve as it confronts how to slow the economy with higher interest rates at the same time it moves to stem banking problems.”

According to the Bureau of Labor Statistics, which compiled these data, the Consumer Price Index rose 6.0% during the 12 months to February. That’s lower than the 6.4% during the year to January, but far above the Fed’s target of ca. 2%. On the one hand, the latest data indicate that CPI is increasing at the slowest pace since September 2021. On the other, price pressures are persisting and even intensifying in key sectors of the economy.

Core prices (that is, other than energy and food, which are typically CPI’s most volatile components) rose 0.5% in February, the largest monthly gain in five months; and costs of shelter (which constitute almost 40% of the index, its biggest component) soared 0.8%, matching the largest monthly gain since the 1980s.

According to the WSJ, some economists reckoned these data “underscored the urgency of the Fed’s inflation fight. Several said they thought it made officials more likely to raise rates next week by a quarter percentage point as long as the banking sector didn’t appear to come under additional stress ahead of its rate decision.” On the other hand, the Fed’s meeting on 21-22 March “could feature an intense debate over the benefits of holding rates unchanged to provide more time to see if the banking crisis eases versus continuing to raise rates to avoid creating new confusion over the central bank’s approach to controlling inflation.”

Figure 3: U.S. CPI, Core and Non-Core Components, Annualised, February 2022-February 2023

Using data from the Federal Reserve Bank of St Louis, Figure 3 disaggregates the CPI into two components: “core” excludes volatile elements (namely energy and food); “non-core” adds energy and food; and the sum of core and non-core equals the “headline” CPI. Three results are paramount:

1. Consumer price inflation as a whole has decelerated: it increased at an annualised rate of 7.9% in February 2022, and accelerated to 9.1% in June; since then, it’s slowed to 6.0% in February 2023.
2. “Headline” CPI has slowed because its “non-core” component has collapsed: it accelerated from 1.5% in February 2022 to 3.1% in June; since then, however, it’s decelerated to 0.5% in February 2023.
3. Accordingly, “core” CPI – the component the Fed watches most closely – has hardly budged: it increased at an annualised rate of 6.4% in February 2022, slowed to 5.9% in July, accelerated to 6.6% in September, and decelerated to 5.5% in February 2023. Over the past year it’s shown no trend – and has thus continuously and greatly exceeded the Fed’s 2% target.

Should Jerome Powell match his tough words at the beginning of the month with tough action later this week – and, according to some, risk fanning the embers of the banking crisis? Or should he pause and risk embedding higher consumer price inflation – and thus be forced to lift the funds rate harder and higher down the track?

“Whichever of these two evils the Fed chooses,” wrote James Kostohryz on Seeking Alpha (13 March), “would have very deleterious impacts on the U.S. equity market. The former evil would be felt immediately. The latter evil would likely be experienced over the course of a longer period.”

What might be the implications for Australia? In particular, and as many are asserting in the wake of last week’s bank failures in the U.S., will the RBA pause or even begin to reverse its campaign of rate rises? Its major policy rate, the Interbank Overnight Cash Rate, is currently 3.60%. The Fed’s effective funds rate is presently 4.57%. Hence their differential is ca. -97 basis points (i.e., 3.6% - 4.57% = -0.97%).

Figure 4: the Interest Rate Differential, Australia versus the U.S., Quarterly, Imputed in January, February and March

Assuming for the sake of illustration that the OCR remains unchanged at 3.6% for the rest of this year, Figure 4 re-expresses Figures 1 and 2 in terms of the Australia-U.S. interest rate differential. For example, in January futures markets implied, on average that on 31 March the federal funds rate would be 4.86%; hence the estimated interest rate differential is 3.6% - 4.86% = -1.26%. Two results are most significant:

1. From January to the first week of March, futures markets implied that the differential at the end of each quarter would increase (that is, become more negative) during the first three quarters of this year, approaching -200 basis points in September, and then decrease marginally in December.
2. During the second week of March, the differential grows from March to June but then shrinks (becomes less negative) well below -100 basis points during the second half of the year.

The continuation of a negative differential of -100 basis points or more is implausible. Either because the Fed’s fund rate falls considerably or the RBA’s OCR rises substantially, I expect that during the next 6-12 months the differential will become much less negative, i.e., that the RBA’s OCR will more closely approximate the Fed’s funds rate. 

Ironically, although the RBA’s recent publications and statements ignore the interest rate differential, its web site doesn’t. Indeed, it identifies the very risk that its Governor is apparently ignoring!

The Interest Rate Differential

“Australia’s interest rate differential,” says the RBA’s web site (Drivers of the Australian Dollar Exchange Rate), “measures the difference between interest rates in Australia and those in other economies. (It) is a key driver of the demand for, and supply of, Australian dollars. It is also an important driver of capital flows, which measure the money that flows into, and out of, Australia for investment purposes.”

The RBA continues: “for the Australian dollar, the focus is typically on the difference between Australian interest rates and those in the major advanced economies, such as the U.S. ... Because the interest rate differential is a key driver of exchange rates, the RBA's monetary policy decisions play a key role in influencing the exchange rate.” Then comes what for my purposes is the first of two key points:

“All else being equal,” says the RBA, “a decline in Australian interest rates contributes to the exchange rate being lower than otherwise.”

Interest rates affect the dollar’s exchange rate. How, in turn, does a change of the exchange rate affect consumer price inflation – and thus the RBA’s target OCR? Elsewhere on its web site (Exchange Rates and the Australian Economy) the RBA expresses my second key point: 

“In principle, a depreciation of the exchange rate will increase (consumer price) inflation.” Consequently, “the Reserve Bank may need to tighten monetary policy in order to achieve its inflation target.”

The RBA doesn’t explicitly say so, but the logic is clear:

If the interest rate differential induces a depreciation of the exchange rate, and if the depreciation contributes to an increase of consumer price inflation above the RBA’s 2-3% target, then it will lift its policy rate – which, all else (particularly other central banks’ actions) being equal, will tend to narrow the differential. A large differential at one point in time thus sets in train a chain of events that narrows it down the track. Over time, in other words, the Australian interest rate differential will mean-revert.

What Interest Rate Bulls Are Overlooking

Using data compiled by the RBA and Federal Reserve Bank of St Louis, Figure 6 plots these two rates’ differential. Observations greater than 0% indicate that the RBA’s policy rate exceeds the Fed’s; a differential of 0% means that the two rates are equal; and differentials less than 0% signify that the RBA’s policy rate is below the Fed’s.

Figure 6: Differential, RBA’s OCR and Fed’s Effective Funds Rate, Monthly, Apr 1976-Mar 2023

The mean differential is 2.29%; the RBA’s OCR exceeds the Fed’s effective funds rate by an average of 229 basis points. During the past several years, however, the differential has been negative – and the current differential is among the most negative since the early-1980s.

Remember what the RBA said about the differential: it “is a key driver of exchange rates.” Specifically, a decline in Australian interest rates (relative to those in the U.S.) contributes to the exchange rate being lower than otherwise.”

Figure 7, which plots data compiled by the RBA, corroborates this expectation. The average exchange rate since January 1969 is $0.87, but the current one ($0.659 on 9 March) is the lowest since the Global Viral Crisis of 2020. And apart from the GVC, the current rate is the lowest since the GFC; and except for the GVC and GFC, the current rate is the lowest since the early-2000s (when it crashed to $0.49 in March 2000). Today’s $A-$US rate of exchange, in the words, is among the lowest in 40 years.

Very roughly (albeit not month-to-month), the series in Figures 6 and 7 are correlated: the greater is the interest differential, the higher is the exchange rate – most notably in the late-1970s and early-1980s. Conversely, the lower is the differential, the lower is the exchange rate. That’s the situation today.

Figure 7: the $A-$US Exchange Rate, Monthly, January 1969-March 2022

Recall the RBA’s words: “in principle, a depreciation of the exchange rate will increase (consumer price) inflation ... Should (it) contribute to excessive inflation, the RBA may need to tighten monetary policy in order to achieve its inflation target.” Its own words segue to my most fundamental point.

The Crucial Problem – and Risk – the RBA’s Ignoring

For each month since April 1976, I computed the interest rate differential during the next six and 12 months. I then rank-ordered these data by the current month’s differential; divided them into five sets (“quintiles”) containing approximately equal (net of rounding) numbers of observations; and in each quintile computed the average (1) current differential and differential during the next (2) six and (3) 12 months. Table 1 summarises the results.

Given an extreme differential at one point in time (say, one that falls within the ranges of Quintile #1 or Quintile #5), the differential in six and 12 months’ time becomes less extreme. Imperfectly and with variable lags, the RBA’s policy rate tracks the Fed’s.

Table 1: Differential between RBA’s OCR and Fed’s Effective Funds Rate, Monthly, Apr 1976-Mar 2023

The current differential, as previously mentioned, is -0.97%. That falls within Quintile #1, that is, among the 20% of months since April 1976 whose differentials are most negative (specifically, the current observation ranks among the lowest 8% of all observations since April 1976). Quintile #1’s average differential is -1.32% (-132 basis points) – not much different from the current one. And the imputed differentials in Figure 4 (of up to -200 basis points), which is premised upon a pause by the RBA, are even more extreme.

The problem for interest rate optimists is that after six months differentials in Quadrant #1 tend to narrow to an average of -48 basis points, and after a year the negative differential becomes positive (14 basis points).

What does that imply? If current prices in interest rate futures markets are roughly correct (that’s a hazardous assumption; we’ve seen that they’re quite volatile), on 30 September the Fed’s funds rate will be 4.63%. If the Australian interest rate differential continues to mean-revert as it has since the mid-1970s, then in six months it will narrow to -0.68%; in other words, by simple algebra (where x = the RBA’s OCR on 30 September) we have x – 4.63% = -0.68%; solving for x, we have x = -0.68% + 4.63% = 3.95%, i.e., the RBA will hike by 25 basis points over the next six months. That’s well within the mainstream’s expectations.

But what if the current bank ructions quickly dissipate and the federal funds rate imputed in futures markets returns to its average level in the first week of March? If so, then on 30 September the federal funds rate will be 5.56%; assuming an interest rate differential of -0.68%, that implies an OCR of 4.88%, i.e., the RBA will boost the OCR by ca. 125 basis points from its current level. 

That, to put it mildly, is well outside the mainstream’ expectations – and would shock Australian markets it if it occurred.

What Does It All Mean?

Over the past year, the RBA’s publications and Philip Lowe’s public statements have ignored what its web site makes plain: an increase of the Fed’s funds rate, which widens the rates differential and tends to depreciate the $A’s exchange rate, can (through the rising prices of imports) place upward pressure upon consumer prices – which, if the CPI rises above the RBA’s target, it must combat by lifting its target for the OCR.

The RBA surely doesn’t fail to notice – but apparently chooses to obscure – the crucial fact that ultimately it cannot act independently of the Fed. Presumably it conducts its “independence” pantomime to distract attention from the fact that its autonomy is a myth.

On 8 March, Philip Lowe stated that there are “four really important pieces of data that we’ll (examine) at our next board meeting.” They are: the ABS’s latest estimates of (1) unemployment, (2) consumer price inflation and (3) retail trade and (4) the results of NAB’s latest business survey.

Taking Lowe at his word, he’s saying that the RBA focuses mostly upon irrelevancies. What actually guides its actions and sometimes forces its hand is (a) the Fed’s current federal funds rate, (b) estimates of the funds rate in futures markets, (c) the interest rate differential and (d) the differential’s effect upon the $A-$US exchange rate and CPI.

Less than two years ago, the $A-$US exchange rate exceeded $0.78; earlier this month, it dipped below $0.66. That’s a depreciation of more than 15%. If it sags much further, into the low-60s, it’ll likely become an issue – and the RBA may have to intervene in order to (1) tamp the exchange rate’s impact upon consumer price inflation and (2) defend its increasingly tarnished reputation.   

Australian commentators imitate the RBA’s myopia – and thereby greatly exaggerate its omnipotence. “Whether the landing is soft or hard,” Alan Kohler reckons, “is entirely in the hands of the Reserve Bank” (see The RBA has forgotten its job, 10 March). Sorry Alan, that’s simply wrong: that power belongs largely to the Federal Reserve.

The mantra “Don’t fight the Fed” means that investors should align their actions with the American central bank’s because if they do otherwise they’ll incur financial or reputational loss. But it’s not just investors who can’t fight the Fed: neither can central banks like the RBA.

The Bottom Line

It’s important to emphasise: expectations about the federal funds rate can and do change considerably, quickly and unexpectedly. Hence it’s prudent to incorporate into one’s plans what the RBA overlooks: the regression of the interest rate differential regresses towards its long-term mean. This might occur in several ways – more than one of which entails higher policy rates:

1. If the turbulence triggered by American bank failures and Credit Suisse’s wobbles doesn’t soon dissipate, the Fed cuts its target funds rate and the RBA stands pat, then the Fed resolves the RBA’s dilemma.
2. If the turmoil quickly dissipates, then the Fed continues to lift its policy rate and the RBA follows.
3. If the Fed pauses, the tumult dissipates and “core” CPI persists well above the Fed’s target, in a few months it may belatedly “slam on the brakes” with multiple and hefty increases of its funds rate – and the RBA will be obliged to take even more drastic action.

That’s why Leithner & Company continues to incorporate into its plans the risk – as opposed to the expectation, never mind the certainty – that consumer price inflation becomes stuck above central banks’ targets, and that their policy rates of interest rise significantly higher and remain higher longer than most people expect (or fear).

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