Why higher interest rates are the new normal

Trying to guess where interest rates might move from month to month is a favourite pastime for many people in the financial markets (not to mention finance journalists).

And lately, we’ve all had plenty to speculate about. The surging oil price is making our inflation problem worse, prompting markets last week to price in up to three more Reserve Bank interest rate rises, which would push the cash rate above 5 per cent.

As dramatic as that would be, however, this column isn’t about what the RBA might do to interest rates this month or at the meeting after that. Rather, it’s about where rates are likely to gravitate in years ahead, and I’m afraid the recent news on that front is not what borrowers want to hear.

Economists and market experts lately have predicted rising global interest rates in the long term, and that’s likely to mean we end up with higher rates in Australia.

The causes are not only increasing inflation but also global “megatrends” as the rise of artificial intelligence, growing geopolitical conflict and decarbonisation.

Quite a bit, according to the “neutral interest rate,” an economic concept that’s big in the world of central banking.

Raising interest rates is akin to hitting the economic brakes and cutting rates is like stepping on the accelerator, while the neutral rate is just that – one that neither stimulates nor slows the economy.

The dismal science of economics is known for being theoretical, but even here the concept of a neutral rate is fuzzy. It can’t be measured or observed, as with the unemployment rate can, and it changes over time.

Instead of measuring it, economists attempt to estimate where the neutral rate might be, and then use that in their analysis of whether interest rates should be more expansionary or contractionary.

It can get highly technical, but the key point is this: market economists believe the neutral rate has been steadily rising in recent years.

Commonwealth Bank’s senior economist Trent Saunders last week said CBA had lifted its estimate of the current neutral rate to 3.85 per cent, up from 3.7 per cent in July and 3.25 per cent last October.

These estimates have risen partly because our economy has been surprisingly resilient – it’s held up better than expected against three rate rises this year, for example.

There is a much bigger global story, as estimates of “neutral” interest rates have also risen around the world since the pandemic. This is where the huge trends of our era – such as AI, increased military spending and decarbonisation – come in.

Economists say that what ultimately sets global interest rates in the long term is the balance between savings and investment.