What do higher US interest rates mean for Australia?
In March, the US central bank – the Federal Reserve – lifted its federal funds rate target and forecast at least two more increases by the end of 2018. The latest rise of 25 basis points brings the range to 1.5 per cent – 1.75 per cent.
Interest rates are a way of showing the strength of a country’s economy in the eyes of the central bank. So if the US Federal Reserve takes action to raise rates, it is demonstrating that it believes the US economy is strengthening.
Of particular interest is that for the first time in 17 years, the US federal funds rate has surpassed the Australian equivalent, the official cash rate. The last time this occurred was in the period between July 1997 and December 2000.
In Australia, our central bank – the Reserve Bank of Australia – has kept the cash rate at a record low of 1.5 per cent for 19 consecutive months.
So why are we in Australia concerned with rates in the United States?
The federal funds rate is the rate at which banks lend to other banks on an overnight basis, and like the cash rate here in Australia is a major factor in influencing interest rates. When US rates go up, the US dollar tends to follow suit – although this doesn’t always happen. Higher rates reduce inflationary pressures and this works to appreciate the US dollar.
When the Fed lifted rates this time, the US dollar actually fell. This comes down to expectations. In this situation, the fall in the greenback suggested that the foreign exchange market was disappointed the Fed suggested it was only likely to raise rates three times this year rather than the expected four.
Many Australian companies – particularly our banks – borrow money in US dollars as the US dollar is viewed as the “world’s currency”. Higher borrowing costs for banks that result from a higher US dollar tend to be passed onto their customers in the form of potentially higher lending rates.
Higher US rates are not necessarily a bad thing for Australia. It may ease some of the pressure in housing markets, for example. They may also put downward pressure on the Australian dollar and this is a positive move for sectors that benefit from a lower currency, such as tourism.
Deloitte Access Economics partner Chris Richardson told 9Finance that while a downtrend in the Aussie dollar will be good news for Australia, the rising trend in the cost of capital would eventually hurt us, relative to our incomes. “Australian families have borrowed more than any other nation bar the Swiss,” he says.
Just because the Federal Reserve has lifted the federal funds rate, it doesn’t mean the RBA will follow. Whether the RBA lifts the cash rate in Australia is down to how it feels the economy is performing. At its March board meeting, for example, it left the cash rate unchanged – a move that was expected following weak inflation and business investment figures.
Nomura interest rate strategist Andrew Ticehurst told the Australian Financial Review that Australia’s GDP has been below potential for the past four years and there is more spare capacity.
“We believe it is appropriate for the RBA to display more patience under these circumstances,” he says. “However, the RBA appears to have gained more confidence that things are moving in the right direction and that this will likely continue – that is, unemployment should gradually fall and inflation gradually rise.”
The general consensus is that the Australian cash rate is likely to remain on hold for the foreseeable future. Higher rates will likely send the Australian dollar higher, which will hurt our exporters and subdue the economic recovery the RBA is keen to ensure it is firmly in place.