Timing of US and Australian interest rate changes may diverge in the year ahead

March quarter CPI data is key to rate cut timing

The Consumer Price Index (CPI) for the March quarter will be released by the Australian Bureau of Statistics on 24 April and holds the key to the timing of any rate cut by the Reserve Bank of Australia.

The December quarter 2023 CPI rose 0.6 percent and over the twelve months to 31 December 2023, the CPI rose 4.1 percent. Market consensus is for a 0.8 percent headline CPI increase for the March quarter, taking the annual inflation rate to 3.5 percent annually. This would be the lowest rate since December 2021.

It is a different story in the US where inflation is measured and reported monthly. Australian inflation data is measured and reported quarterly. The most recent US inflation data showed a stronger than expected 3.5 percent increase in March, up from a 3.2 percent increase in February. This unwelcome and unexpected rise will not sit well with the US Federal Reserve Board and suggests that the Federal Reserve’s 2 percent inflation target may take longer than expected. Inflationary pressures in the US are higher than in their counterparts, which is unsurprising because weaker economies have less inflationary pressure. The US Federal Reserve previously hinted at rate cuts commencing toward the end of 2024, however until US inflation data shows signs of peaking, talk of any US rate cut is premature.

RBA better placed than US Federal Reserve to cut rates earlier

Mortgage rates are higher in Australia compared to the US. More than ninety percent of US mortgages are on fixed rates, while about seventy percent of Australian mortgage holders are on higher variable interest rates.

The high proportion of fixed rate mortgages in the US means that US mortgage rates have on average risen by just 0.5 percentage points, compared to 3.2 percentage points in Australia. This is despite the US Federal Reserve Official interest rate being set at 5.5 percent and the RBA cash rate in Australia being lower by 1.15 percent, at 4.35 percent. This means that Australian households are more sensitive to Official interest rate changes than their US counterparts. As a result, this situation leaves the RBA in a better position to reduce the Official cash rate earlier than the US Federal Reserve, should the need to do so arise.

The currency market is telling a similar story in that the Australian dollar is currently trading at 64 cents against the US dollar, compared to 66 cents on 9 April and 68 cents on 2 January. The expectation of higher interest rates for longer in the US is increasing the value of the US dollar against the Australian dollar, because international investors constantly seek out the highest yield on their funds, increasing demand for the denominated currency in which the highest yields are on offer. This explains the adage that ‘money never sleeps’.

RBA current position on rate cuts

The RBA recently noted that lenders have been slower to increase the average outstanding mortgage rate relative to the RBA’s Official cash rate over the current tightening cycle compared to previous tightening phases. This is attributable to the high share of loans at historically low fixed rates taken out during the pandemic. The RBA expects the average outstanding mortgage rate, relative to the Official cash rate, to increase further as more fixed-rate loans expire. Consequently, the extent of interest rate pass-through by the end of 2024 is anticipated to be similar to previous tightening cycles, implying that more impact of the RBA’s tightening cycle is yet to be felt. This diminishes the likelihood of further Official interest rate increases in the period ahead and clears the way for a more favourable interest rate outlook to be included in the RBA’s next Statement on Monetary policy.

According to the RBA, the Australian economy is forecast to grow at an annual rate of around 2 percent per annum and the inflation rate is anticipated to be back to the RBA’s 2-3 percent target range in 2025.

If the RBA forecasts are accurate, the RBA may consider reducing domestic interest rates in the second half of 2024 if geo-political risks escalate, resulting in slower than expected economic growth in Australia.

If signs of a slowing economy emerge, the RBA may consider reducing domestic interest rates in the second half of 2024.