Chart of the Month - July 2024

No, r-star doesn’t stand for “rock star”! Rather, it is the official cash rate that has a neutral impact on an economy: neither contractionary nor expansionary.

It is critical for both central bankers and investors. R-star is the interest rate that central bankers aim for in the medium and longer term. While it is not a perfect measure, it provides an important guide. For investors, knowing r-star, helps them figure out the path of monetary policy over the medium term. The distance to r-star provides clues on how far the current interest rate cycle will run.     

The chart below shows Australia’s average r-star (or neutral interest rate) as estimated by a range of models as well as the range in the model estimates.

The current interest rate cycle and r-star

When inflation started to accelerate in late 2021, the RBA’s cash rate was close to zero at 0.10%. This was well below the average r-star and had been since 2013. This points to an economy deep in expansionary mode - too deep.

The RBA had got deep into expansionary territory after it began cutting interest rates in 2011 and 2012 in response to a slowing global economy and an Australian economy that was coming down from a peak in capital investment by the mining industry, and a peak in its terms of trade (see chart below).

“Commodity prices have firmed noticeably from recent lows, but this follows very substantial declines over the past couple of years. Australia's terms of trade remain much lower than they had been in recent years.” Statement by Glen Stevens, Governor: Monetary Policy Decisions, 3 May 2016.

The RBA again cut rates during 2019 as it watched to see the impact of Trump’s tariffs on China. And then it cut rates in response to the outbreak of the COVID-19 pandemic in 2019.

By this time, Australia’s cash rate was well below r-star and the Australian economy could not get any more expansionary. This was also the case for many other economies with the UK, US, and euro area with interest rates at or below zero.

As pandemic supply shocks saw inflation start to accelerate in late 2021, the RBA switched to vigilance mode. Like most central banks it initially believed that inflation was transitory.

“While inflation has picked up, … There are uncertainties about how persistent the pick-up in inflation will be as supply-side problems are resolved.” Statement by Philip Lowe, Governor: Monetary Policy Decision, 1 February 2022.

The RBA woke up to the threat of inflation, a little later than other central banks, with its first rate rise in May 2022. The UK and US began raising rates in December 2021 and March 2022 respectively.

So far, the RBA has increased rates by 425 bps during this cycle, the UK and US: 515 and 525 bps respectively. There is thus an argument that the RBA has not pushed its monetary policy lever far enough to the restrictive side. This has been confirmed in the minds of some with inflation stubbornly refusing to come down over the last few months and the RBA’s preferred inflation measure, trimmed CPI, actually increasing.

“No sugar coating it, the only way is up for rates.” Warren Hogan, economist, Judo bank.

What r-star can tell us about what happens next

The cash rate is already above r-star so the RBA could just keep the cash rate where it is until inflation starts moving down again. This would be the RBA’s preferred path as it knows that an interest rate increase now could push the Australian economy over the edge into recession. It would also be ammunition for critics that believe that the RBA has not been hawkish enough during the current interest rate cycle.

“Financial conditions are particularly restrictive for households, but less so for larger businesses.” Christopher Ken, Assistant Governor (Financial Markets), RBA, speech at ABA Banking Conference, 26 June 2024.

However, if the June quarter inflation results, released on 31 July, surprises on the upside, the RBA will be forced to increase the interest rate.

“Members acknowledged that if inflation expectations were to rise materially from current levels, it could require significantly higher interest rates to bring inflation back to target, with adverse implications for growth in output and employment.” Minutes of the Monetary Policy Meeting of the Reserve Bank Board, 17 to 18 June 2024, released 2 July.

A declining r-star

Our chart of the month shows that r-star has generally been declining over time. This has also been the case in other advanced economies such as the US (see chart below). In other words, economies have needed an ever lower interest rate to attract new investment. Possible causes include lower productivity growth over the last decade or so, a glut in global savings, and even Larry Summers’ secular stagnation resulting in less investment per dollar of savings.

However, Australia’s r-star has increased since the pandemic. According to the RBA this reflects increases in public debt, downward pressure on savings, retiring baby boomers, and investment in the green transition.