With the economic slowdown becoming locked in, both in Australia and around much of the world, economists and financial markets are increasingly comfortable with forecasts that the end of the interest rate hiking cycle has been reached.
The overwhelming view is that the mass interest rate hiking cycle - which is as far and wide as the US, Canada, New Zealand, the UK and the Eurozone - is over, even with the European Central Bank hiking again this week.
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The reason for this view is simple: economic growth is slowing, unemployment rates are rising and inflation has fallen. Add to this the still yet-to-be-felt full impact of the interest rate hikes and there is a widely held assessment from most central bankers, economists and market participants that a period of steady interest rates - albeit at a high level - is getting underway.
This begs the question: if interest rates are at a peak and there are no more rate hikes, the next move in rates is lower. When will that be?
Before we all get too excited about the start of an interest rate cutting cycle, a few vitally important things need to unfold.
Inflation and unemployment
History shows a few key benchmarks have to be reached before central banks deliver interest rate cuts. And it’s not just one of these issues that has to show up in the economic data. It is a closely interlinked combination of all of the inflation and unemployment.
As central banks operate with the primary focus of a target for inflation, an interest rate cutting cycle will only kick off if actual and expected inflation is consistent or at the lower end of the target.
In Australia, and the western world, we are not quite there yet. Sure, inflation has been in free-fall from the peak in mid to late 2022, but the glide path for inflation to settle around the target ranges is still unfolding and, indeed, could be postponed by the recent upturn in commodity prices. Note the rise in global oil prices, which is showing up in higher petrol prices, as one high-profile example.
For an interest rate cut to be delivered, inflation needs to consolidate a bit lower than is currently being seen.
The other key issue for an interest rate cut to be delivered is a rise in the unemployment rate. Rate cutting cycles only start when there has been a deterioration in the labour market – higher unemployment, in other words. The broader economic slowdown evident since the latter part of 2022 is starting to have an impact on the unemployment rate.
In the US, for example, unemployment fell to a five-decade low of 3.4 per cent in January and April 2023 and, while the month-on-month data are volatile, in August the unemployment rate rose to 3.8 per cent. The trend towards higher unemployment is clear, but for the US Federal Reserve to cut interest rates, the unemployment rate, as a rule of thumb, needs to rise by around 1 percentage point from the low before the rate cutting cycle starts.
The market consensus is for the unemployment rate to rise to 4.5 per cent in the middle to latter part of 2024.
For Australia, it is a remarkably similar story. The unemployment rate fell to a 48-year low of 3.4 per cent in October 2022 and, in August 2023, the unemployment rate has trended up to 3.7 per cent. Like in the US, the broad view is for the unemployment rate to hit 4.5 per cent by mid to late 2024. This is about when the rate cutting cycle can commence.
Market pricing can change as the economy and data unfold.
But, as these key influences on inflation and unemployment have unfolded, the market has moved to price in steady interest rates for the next 12 months.
The pricing at the end of 2024 and into 2025 is for the start of an interest rate cutting cycle. At this stage, the cuts are moderate.
But, if inflation falls more rapidly and unemployment rises sharply, the pricing of those cuts will be brought forward and will be more aggressive.