Why this former RBA official believes there are no rate cuts on the horizon

In 28 years at the Reserve Bank of Australia, Dr. Jonathan Kearns has seen it all. When Kearns joined the central bank in early 1995, the cash rate target was a staggering (at least by today's standards) 7.5%. When he left the RBA in March this year, it was 3.6%. 

While the interest rate is not a KPI for judging the RBA's performance, it is the most public of all the metrics. After all, everything from mortgage rates to bond prices and equity market valuations are affected in some shape or form by interest rates. 

Kearns was right at the heart of this issue when he was the Bank's head of domestic markets. Before that, he spent several years overseeing financial stability. He was also a contributor to the RBA Review which was recently released.

These days, he has a new title as the inaugural Chief Economist at Challenger. And for the first time since he took the job, he's sitting down for an extended conversation about the RBA, economic policy in Australia, and what he is hoping to contribute in his new role.

Note: This interview was taped on Wednesday 17 May 2023.

EDITED TRANSCRIPT

Kearns' thoughts on the RBA Review

Overall, Kearns feels the RBA Review hit most of the right notes but that its recommendations are more a "catch up" to other peers rather than introducing something revolutionary. Moving forward, Kearns wants to see more information on the future composition of the monetary policy-setting board. 

"There is a much larger representation of outsiders to insiders compared to any other central bank. The recommendation is they will be experts but who are those experts and are enough of them for the turnover that has to happen," Kearns told me. 

Kearns stopped short of saying the RBA was broken but did argue it was long overdue for a renovation. He also argues that an earlier review would not have affected the Reserve Bank's big miss on inflation nor does it take away the huge gamble it's now facing.

"The RBA, in a sense, is taking a bet that it can increase the interest rates by less to avoid an increase in unemployment and a recession. But I think it's bit of a risk," he said. 

The central bank's misjudgments

One of the RBA's long-running axioms during the COVID-19 pandemic was that Australian consumers were very resilient. Wallets were large, household savings as a result of government stimulus were plentiful, and economic indicators like retail sales remained buoyant for a long time. 

But now that higher interest rates are feeding through to mortgages on top of already high food prices and soaring rents, the split between well-off consumers and less-well-off consumers is now more apparent than ever.

So did the RBA make a major error assuming that all consumers would come out of the pandemic financially better?

"We've been surprised many, many times - just think of the housing market during the pandemic. Everybody expected housing prices to fall significantly but households responded in a way that they valued housing given the nature of the pandemic," Kearns said. 

Naturally, the other major surge that all central banks missed was inflation. It's still the topic de jour and for Kearns, the thorn in the RBA's side is not where inflation is but where it sits with consumers.

"The key is what really happens to inflation expectations and wage setting. The RBA is aiming for what some would call an "immaculate disinflation" ... and if that transpires, it will be a remarkable achievement," Kearns said.

For now, inflation does remain too high and he believes there will be at least two more rate hikes needed to quell the price surge. He adds the RBA may be erring on the side of a terminal rate that is lower than other central banks but keeping it there for longer.

How investors are dealing with today's economic challenges

As part of Kearns' new role, he sits in on the Challenger investment committee meetings. This allows him to contribute high-level economic research to a forum where investment decisions are made on behalf of clients across the fixed income spectrum. With this in mind, I asked Kearns about the debates the committee has been having of late.

"It's about how we position ourselves given the current change in the economic environment. We're seeing this big increase in rates and credit spreads," he said. 

"There's the ability given higher rates and spreads to move back into a lower degree of risk without trading off for lower yields."

Put simply, high-quality corporate bonds are generating some of the most attractive opportunities around today. 

More broadly, Kearns doesn't buy the rates market's view that interest rate cuts will come this year. As for the question of whether Australia can avoid a recession:

"Does the unemployment rate increase by 1%? Probably. But it's equally likely that it will increase by more than that - and that's when it starts feeling like a recession," he said.