Higher interest rates are coming – could something even worse follow?

All eyes are on the Reserve Bank of Australia boss ahead of another widely expected rate hike next week, but it was a warning from her counterpart across the ditch that grabbed many economists’ attention.

As central banks around the world ramp up their fights to tackle inflation – caused in part by the Iran war – concern is increasing about what happens if the interest rates pendulum swings too far in the other direction.

The Reserve Bank of New Zealand clearly defined those fears as it held rates at an enviable 2.75 per cent – compared to 4.6 per cent in Australia – on Wednesday.

“The world economy could tip abruptly into a downturn causing weaker inflation over the medium term,” New Zealand’s central bankers said.

They even put a timetable on it, declaring that “information arriving over the next six weeks could meaningfully change” their stance on interest rates.

Uncertainty dominates, amid questions about whether the war in the Middle East will escalate and drive energy prices even higher and if the astonishing amount of money being tipped into the artificial intelligence boom will prove to be a bust.

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Millions of Aussies expected to be burnt after another scorching inflation read

In the short term, the markets are pricing in an 82 per cent chance of another interest rate hike, to 4.85 per cent, after the board’s next meeting on Melbourne Cup day.

Westpac Group chief economist Luci Ellis expects the RBA to shake off concerns about rising unemployment and falling house prices to hit mortgage holders again.

She pointed directly to the RBNZ’s comments about the risk of a sudden global economic downturn. 

“Whether on this timetable or something more drawn out, this possibility does not appear to be on the RBA’s radar,” Ellis said. 

“Nor is it our base case, though we have previously worried that the AI financing boom could hit a wall quite suddenly.”

For now, inflation is still way beyond the RBA’s target range of 2 per cent to 3 per cent. New figures released as governor Michele Bullock and several of her closest advisers copped a grilling in Senate estimates hearings put the bank’s preferred trimmed mean figure at 3.6 per cent. 

Headline inflation surged more than expected, to 4.3 per cent, the highest figure since March.

“We are not alone in being concerned about inflation – central banks in many other advanced economies are responding by increasing their policy rates or signalling they will do so if needed,” Bullock told estimates on Wednesday.

She reiterated that the problem was not solely due to fuel prices and the conflict in the Middle East but also driven by domestic demand, including government spending.

The governor played down concerns about the housing and jobs markets, saying the unemployment rate “probably will be rising a bit further”.

House prices had fallen but were still about 50 per cent higher than in early 2020, she said.

Her deputy, Sarah Hunter, sought to douse concerns of a recession.

“At the moment our assessment is that none of those indicators are suggesting that the economy is in or heading into a recession in the near term,” she said.

“So that's not what we're seeing or expect to see over the forecast horizon.”

AMP economist My Bui and deputy chief economist Diana Mousina said the RBA’s credibility would take a hit if it didn’t hike rates for a fifth time this year. 

“The question is whether this is enough to ‘get the job done’ on inflation,” they wrote on Wednesday. 

“There are signs that the economy is slowing … which should help to ease inflation. 

“The hope is that inflation slows without crashing the economy. We see GDP growth low in the next 12 – 18 months, but we think a recession will be avoided.”

The RBA is desperate to avoid a situation where inflation becomes “entrenched”, with businesses considering 3 to 3.5 per cent the new normal. 

“There's just some sign that some companies might be thinking, ‘You know what, maybe prices aren't going all the way back, and if they're not, we're going to have to take that into account’ in their pricing decisions,” deputy governor Andrew Hauser said.

“It isn't a klaxon. It isn't my nightmare yet, but it is something we're watching quite closely.”

One thing just about everyone seems to agree on is that AI investment is part of the inflation problem as it props up ailing economies around the world and sends prices for some tech parts skyrocketing.

There are also fears it could prove to be part of the recession problem.

Bullock said investment in data centres in Australia had been “much stronger than we thought” and was adding to demand in the economy.

Assistant governor Brad Jones said the question was whether the markets had “gotten ahead of themselves”.

“It's not for us to, I think, to suggest that there's an irrational amount of exuberance, but there's clearly been exuberance in this space, if you look at earnings expectations and the amounts of debt that is now starting to be deployed to fund some of this expansion,” he told Senate estimates.

“So at the moment we're not at DefCon One on AI-related imbalances in the financial markets, but it's a clear watch point because we are seeing risk appetite increasing in a pretty notable way around the world.”

The NZRB said it was unclear if the surge in AI investment would be “justified by economic fundamentals”.