ROI-Warning from 'Down Under' may unsettle the Fed: Mike Dolan

The world's central banks - and many bond investors - may look at Australia's decision on Tuesday with some discomfort. The Reserve Bank of Australia delivered its first interest-rate rise in more than two years, a move that could herald a broader shift in global credit policy as the world economy heats up again. Japan's peculiar circumstances ‌apart, the RBA is the first major central bank since 2023 to hike rates — and just six months after its last cut.

Although expected by markets, the RBA also leaned hawkish about further hikes. It was coy about whether a new tightening cycle was now underway. But officials were clearly disturbed at their inability to get inflation back to target and doubtful that previous settings were doing the trick. The debate also circles the ⁠thorny concept of where a so-called neutral interest rate may be. It's a question at the heart of the Federal Reserve's conundrum, despite political noise and pressure for it to floor rates even further.

Dismissed by some economists as too vague and elusive a gauge for precise policy calibration, the idea of a neutral policy rate - one which neither restricts credit creation and economic activity nor stimulates them - still guides many central banks seeking to find the ideal equilibrium. After frantic monetary tightening in 2022 to rein in a post-pandemic inflation spike, central banks have collectively dialed back rates over the past 18 months ​as consumer price pressures subsided again. Markets have bet they are at, or close to neutral - and will stay there.

The problem is that in most cases, including Australia and the U.S., inflation has not yet returned to target. And there are signs that economies and credit ‍demand are re-accelerating once more. Citing capacity pressures amid brisk growth in household spending and private investment, the RBA reckoned that inflation would remain above its 2-3% target range "for some time" and pushed interest rates back up. Investors now bet there's a 75% chance of yet another rise in May.

The RBA statement said rather baldly that it seems to have lost sight of its lodestar. "Financial conditions eased over 2025 and it is uncertain whether they remain restrictive." Is it now just feeling around in the dark?

Despite critics of following a barely measurable real neutral rate, often known as "r-star," the Aussie central bank seems to be saying: you know it when you're not there. LOSING YOUR LODESTAR

Extrapolating that pressure out to all other major ⁠central banks may be ‌unfair. The European Central Bank, for example, has managed to get inflation squarely ⁠back to target and seems comfortable that it has found its 'happy place' for now. But the Fed is a very different matter.

Despite the U.S. political push for further deep interest rate cuts and the nomination of Kevin Warsh to take the helm as Fed chair from May, the picture in front of the Fed is one of core inflation ‍still a full percentage point above target, and financial conditions at their loosest since 2021. With U.S. GDP trackers still registering above 4% annualized growth, corporate earnings growth in double digits and labor markets stable, this week saw signs of what looks like a new-year acceleration.

The ISM survey of U.S. manufacturers for January showed factory activity ​surged to its highest since 2022 - the first expansion in more than a year. New orders drove the jump, while input prices continued to rise rapidly. JPMorgan has detailed how that upturn was echoed around the world. January surveys, it argues, point to a ⁠global industrial upturn running at 2–3% at the turn of the year. "The upturn is broadening: the SG Global Cycle Indicator now reads 'Boom'," wrote Societe Generale strategists.

What's more, the Fed's own quarterly Senior Loan Officer Opinion Survey showed business loan demand from large and medium-sized firms in the fourth quarter was the strongest since the second quarter of 2022. It also said banks expect ⁠it to strengthen further this year. Despite all that, many Fed officials have characterized the current policy rate as mildly restrictive - even if it's hard to find where it's bearing down on the overall economy. A subdued housing market is often cited, but that's more down to long-term market rates, which have barely responded to Fed policy easing for more than a year.

Indeed, by some Fed-published estimates of the "r-star," U.S. policy rates are already in stimulative territory. "A genuinely 'hot' economy could come as a nasty surprise, especially for bond markets, which can't see past central banks leaving rates at 'neutral' forever," ⁠wrote TS Lombard economist Dario Perkins.

The RBA and the Fed are different beasts, of course, with vast differences in economic scale. But this week's debate and action "Down Under" may prick up some ears in Washington.

As prospective new Fed Chair, Warsh's billing as something of a hawk seems at ⁠odds with an interview process that likely required his support for big rate ‌cuts in order to secure the nomination. Unless the new-year economic heat turns out to be a flash in the pan, Warsh's toughest task may well be finding a case for any further rate cuts at all.

(The opinions expressed here are those of the author, a columnist for Reuters.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI on LinkedIn, and X.

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