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Is ‘interest rate hike’ scenario coming?

Stephen Koukoulas

2017 has kicked off with money markets starting to price in interest rate increases over the next few years. That’s right – interest rate rises.

The market appears to be focusing on the good economic news from the global economy, especially in the Eurozone which has proved to be a surprise packet with growth picking up and the unemployment rate falling. The US economy is also is a strong position with unrelenting growth in employment and the unemployment rate firmly entrenched below 5 per cent.

Add to that buoyant commodity prices and an export revenue boom in Australia and there we have the ‘interest rate hike’ scenario that the market is looking for.

Also read: Three risks facing the Australian economy

As to timing, the current market pricing has a 25 basis point hike to 1.75 per cent priced in around the middle of 2018 and a further hike about six months after that.

A total of 50 basis points of interest rate rises over two or so years, if correct, would certainly take some heat out of the housing market. It would also trim the growth outlook for business investment and risk driving the Australian dollar higher.

And it is these latter two points which make the notion of higher interest rates seem inappropriate. The current hard data on the economy shows weak overall GDP growth, relative high unemployment, record low wages growth and underlying inflation entrenched below the bottom of the RBA target band. Business investment is also in free-fall, having dropped more than 30 per cent in the last three years and business expectations for future investment are not particularly encouraging.

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All of these indicators, not just some of them, need to strengthen markedly before the RBA would seriously contemplate a rate hike and while there have been a few snippets of better news in some of the lower tier economic indicators over the past month, it is unclear whether this will show up in a sustained improvement in the economy in the next 6 to 12 months with GDP growth back above 3 per cent and the unemployment down to 5 per cent.

On that score, the feedback from retailers was that the Christmas / New Year sales period was that consumers remained cautious and would only spend when there were clear discounts. This suggests that both growth and inflation will remain low, at least into the early part of 2017.

Also of some concern for the growth outlook is the start of a decline in new dwelling construction. There were a record number of new dwelling approvals during 2016, but there are signs the building boom will taper off during 2017. Developers are responding to what is a clear oversupply in a number of cities – Brisbane and Melbourne in particular, which means that through the course of 2017, dwelling investment will likely fall

Any interest rate rise, would exacerbate any downturn.

Money markets do not always ‘get it right’ as the global financial crisis shows all too starkly. Just a few weeks ago, a further interest rate cut was priced into the market which demonstrates just how quickly markets can, and often do move when new economic news comes in.

All of which is to suggest that the market looks to be getting a little ahead of itself in pricing in interest rate increases in Australia. Such moves are unlikely. Perhaps when the run of data turns a little softer over the next few months, especially for consumer demand and housing, the market will change tack again.

Stephen K
Stephen K

 Stephen Koukoulas is a Yahoo7 Finance expert with more than 25 years experience as an economist in government, as Global Head of economic and market research, as Chief Economist for two major banks, and as economic advisor to the Prime Minister of Australia.