Former Governor of the Reserve Bank of Australia, Ian Macfarlane shares his views on inflation and interest rates.
Inflation and interest rates are among the most widely-discussed topics of recent months. While there is no shortage of opinions, very few of them are informed by the experience of having served as the head of a central bank. At Morgan Stanley’s Australia Summit, we had the privilege of hearing from Ian Macfarlane, Governor of the Reserve Bank of Australia from 1996 to 2006. He was thought-provoking and incisive. We revisit some of his key points below.
It’s important to remember how truly extraordinary monetary policy was in the lead-up to the COVID pandemic. For about a decade, the world experienced the most expansionary monetary policy in recorded history, with the US leading the way.
Unprecedented is a word that is overused but it is entirely appropriate in this instance. Zero interest rate policy, quantitative easing, forward guidance – these things had never been tried before in modern monetary policy. They had no precedent in central banking.
In short, this extraordinary starting point means that the experience of past cycles is unlikely to provide a good guide to the future.
It is almost impossible to predict the long-term effects of an extended period of easy money. Less extreme versions of easy money have produced unexpected results in the past. It’s reasonable to assume recent expansionary efforts will produce surprises and challenges that will need to be dealt with.
Related to this point is that it is incredibly difficult to wind back easy money. This was demonstrated in the US in 2019 when an attempt was made to return monetary policy to more normal levels. Money markets seized up before interest rates reached their modern average and long before they reached a level that would be sufficient to dampen inflation. That calls into question the ease with which central banks will be able to raise rates in the short term.
A final point is that the relationship between monetary policy and inflation is incredibly loose. A lot looser than the casual observer might assume given the way they are often connected in commentary. The cash rate is a blunt tool that is incredibly imprecise. It’s worth remembering that it took central banks a decade to tame inflation in the 70s and 80s. Conversely, central banks targeted higher inflation for seven years without success after the 2008 financial crisis.
So, what does all this mean for inflation and interest rates? Macfarlane’s view is that inflation will come down from its peak in 2022 but is unlikely to return to 2%. A figure of 3,4 or 5% is more likely.
Against that backdrop, Macfarlane believes markets are under-estimating how far interest rates will rise in the long term while simultaneously over-estimating how rapidly they will rise in the short term.