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When they don't know what to do
Key takeaways
- Central banks remain reluctant to raise interest rates when economic growth is weak, even when inflation remains above target.
- The key challenge for policymakers is balancing persistent inflation pressures against a deteriorating growth and employment outlook.
- Uncertainty around the neutral interest rate is making it harder for central banks to judge how restrictive monetary policy really is.
- The RBA is likely to remain on hold for now, but the inflation outlook remains vulnerable to ongoing energy price pressures.
Central bankers don’t like to raise interest rates, except under conditions of a booming economy or a directive (implicit or explicit) from the government. Unfortunately for Governor Bullock and the RBA, neither of those two conditions apply at the moment.
The difficult decision to raise rates
So, why don’t central bankers like to raise rates? For the reason most people don’t like to do unpopular things – because it’s unpopular. Why make yourself unpopular, jeopardise your reputation and risk your job if it’s not necessary? Why destroy businesses and individuals’ personal finances with an incorrect rate call? It’s easy to raise rates when inflation is rising in a strong economy – there’s not too much pain from the higher rates. But when the economy is weak, it’s a different story.
Look at the recent track record. Central banks failed to raise rates coming out of Covid, when the economy was weak but inflation was surging. They delayed tightening policy after the outbreak of the Russia/Ukraine war as inflation surged from a high base, eventually being forced to act by the market. And now, following the Iran War, where once again inflation is lifting but in the face of a weakening economy, central banks have proven to be reluctant policy hawks. Rising inflation in a weakening economy is a central banker’s worst nightmare. Even for central banks that do not have the RBA’s or Fed’s dual mandate, such as the European Central Bank and the Bank of England (BoE) (whose mandates are price stability), the decision to raise rates has been torturous.
The BoE is a test case. The Bank began an easing cycle in July 2024, cutting the Bank Rate by 150 basis points to December 2025. Over this period, core inflation in the UK averaged 3.5% and did not fall below 3.2%. In contrast, headline inflation was at target at the start of the easing cycle, but progressively increased to 3.6% over the course of 2024 and 2025, yet the BoE continued to lower the Bank Rate. The outbreak of the Iran war saw the BoE put rates on hold, where they remain to this day despite UK inflation sitting at 3.1%, 1.1 percentage points (ppts) above its target. Note that in the UK, the BoE must write a letter of explanation to the government if inflation is 1ppt above (or below) its target, which is 2.0%.
Central banks have lost their anchor
The usual indecision that plagues central banks in periods of high inflation and tepid growth has been compounded by a loss of the traditional anchor of monetary policy – the neutral rate. The neutral rate is the rate at which monetary policy is neither restrictive nor expansionary. The neutral rate takes on a particular significance in the current environment where central banks need to tighten monetary policy by just enough to break inflation, but not the economy. The neutral rate provides an anchor allowing central banks to gauge how restrictive policy is. For example, if the neutral rate in Australia is 3.5% (which was the accepted wisdom pre-Covid), then the current rate of 4.6% would be very restrictive.
The problem is that a decade of interest rate suppression by central banks following the GFC, distorted the usual relationship between central-bank policy rates and the economy, and consequently, made the neutral rate irrelevant if not non-existent. But the post-Covid return of inflation has ended the anomalous decade of the 2010s and the aberrant era of zero rates and quantitative easing, and monetary policy has once again reverted to its more boring role of raising rates above neutral when inflation is above target and lowering it below neutral when inflation is below target. But at what rate does policy become restrictive, expansionary or neutral? In Australia, the old estimate would have you believe that policy is currently very restrictive. However, the persistence of inflation brings into question this old estimate of the neutral rate that was established in the 2010s. Our best estimate is that the neutral rate is around 3.75-4%, with the risk that it could be as high as 4.25%. This means that at 4.6%, monetary policy is restrictive, but much less so than if the neutral rate was 3.5%.
Where is the RBA right now?
In summary, the RBA will be reluctant to lift rates from here. Governor Bullock said as much on numerous occasions in her press conference following last Tuesday's rate decision. We concur with the Bank that the current cash rate of 4.6% is restrictive, but probably mildly restrictive. Inflation remains a problem with headline at 4% and underlying at 3.6%.
However, economic growth is sub-trend and a rout is looming in the housing market. The labour market is weakening and the unemployment rate is headed towards 5%. At the same time, the Strait of Hormuz remains shut, the oil price remains above US$100/bbl and the threat of a secondary inflation shock looms if higher oil prices pass-through the broader economy. We suspect that inflation can be contained at around 4% (headline) and 3.6% (underlying) until the end of the year. But beyond that, we need to see oil prices falling if inflation is to be contained. Therefore, we see the RBA on hold to the end of the year, with the next serious threat to the current rate of 4.6% coming in February 2027.