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What are central banks doing about interest rates?


The Reserve Bank of Australia (RBA) has implemented an accommodative monetary policy for some time, having left the cash rate unchanged at 1.5% since September 2016.



Meanwhile the US Federal Open Market Committee (FOMC) has started to lift its interest rate and there are signs the European Central Bank (ECB) may be prepared to finally lift rates from zero or below.

Here, we explore the thinking behind the RBA’s most recent cash rate decision, as well as how other central banks are approaching future interest rate decisions.

This is important for self-managed super fund (SMSF) investors as interest rates affect all asset classes in a variety of ways. 

Inputs into decisions

First, let’s look at inflation. This is important as the RBA has a mandate to keep inflation between 2% and 3%.

As the minutes of the May board meeting show, inflation is in line with forecasts and the quarterly inflation data has raised the board’s confidence underlying inflation is likely to increase to approximately 2 per cent by early 2018. 

As the minutes show, “headline inflation has been a little above 2% and underlying inflation had increased to around 1.75%.” 

With inflation more or less within the RBA’s target band, the board turned its attentions to economic growth and other inputs it considers when making interest rate decisions.

Last year GDP growth hovered at about 2.25%, and the RBA’s data suggests the economy grew moderately in the March quarter. The central bank is expecting further, albeit subdued, economic growth for the remainder of 2017.

It’s predicting growth of just over 3% by the first half of next year, as resource exports rise and the economic lag from the end of the mining investment boom fades.

The unemployment rate is another variable the RBA takes into account. It has been hovering at about 5.9 per cent and is expected to slowly drop.

Turning to events in the global economy, which the RBA also factors into its investment decision, the central bank notes in the minutes that economic growth among Australia’s trading partners has been growing.

As the document states, “The stronger activity had been evident in a pick-up in various indicators, including industrial production and measures of business and consumer sentiment, as well as in a broad-based rise in global trade.” 

This has resulted in a lift to business investment in the US, Japan, Korea and China. With the latter, the minutes note, “property construction and government spending on infrastructure had been among the important drivers of growth and had supported Chinese demand for Australian iron ore and coal as inputs into steel production.” 

Nevertheless, the RBA suggested risks in the Chinese economy, especially in the residential property market, remain a concern for Australian exports and the terms of trade.

As the board noted, “Another source of uncertainty was how the Chinese authorities might balance achieving their growth targets with the risks associated with high and rising leverage in the Chinese economy.”

Global markets 

The RBA also closely watches conditions in international capital markets and its most recent board minutes note the relative stability of financial markets in recent months.

It notes, “Heightened geopolitical tensions and various political developments had had little effect on financial markets.”

Aside from global financial markets, the RBA also looks at what other central banks are doing, especially in relation to currency movements: when national interest rates rise, so too does the related currency.
  
In April The Bank of Japan left monetary policy unchanged at -0.1% at its April meeting, but it has left open the door for more quantitative easing so it could reach its inflation target of 2%.
 
The ECB also left its interest rate at zero, unchanged for 10 months, at its April meeting. 

The RBA notes while the FOMC is unlikely to lift its rate of 0.75% to 1% at its May meeting, the market is expecting three increases in the federal funds rate by the end of 2018.

Overall the RBA confirmed its position that the outlook for the global economy remained positive. “The broad-based nature of the data supporting this outlook provided some confidence the expansion could become self-reinforcing,” it said.

This is good news for SMSF investors who have weathered the various financial storms since the financial crisis of 2007/2008.
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