Spiking Australian Interest Rates Are A Glimpse Of The Global Future

Australia has been in the news lately over its aggressive response to the pandemic.

But the bigger Down Under story might end up being interest rates. It seems that Australia’s central bank (RBA) had, like the Fed and ECB, been pegging short-term government note yields at extremely low levels, thus creating the illusion that local financial markets were tranquil and well-managed and not at all prone to sudden collapse.

With inflation soaring, however, it became harder to manage the country’s increasingly unruly yield curve, and finally, the RBA just gave up and let the market decide how expensive short-term money should be. Here’s what happened:

Two very important points here. First, the current surge in price inflation is global, which means every central bank is wrestling with the same financial market instability that just defeated the RBA. So expect similar dilemmas to pop up elsewhere. The next chart, for instance, shows expectations for India’s short-term interest rates.

Second, the new two-year Australian yield of 0.7% seems high compared to the RBA’s previous target, but is minuscule compared to the ~ 5% cost-of-living increases now the norm in most countries. For readers who have forgotten the point of interest rates, they exist to generate a positive real return for lenders. So the expected free-market two-year yield in a 5% inflation world be maybe eight times as high as Australia’s current rate.

Which means the recent action was just an appetizer in a long, tempestuous feast of central bank capitulations followed by spiking rates followed by frenzied back-of-the-envelope calculations of what soaring borrowing costs will do to government deficits. (For the US version, multiply $30 trillion by .06% to arrive at a backbreaking annual government interest cost of $1.8 trillion.)

This will be followed by desperate attempts to force rates back down, which only causes inflation to spike further, and so on.

*********