• Cash rates historically have been set above trend inflation, preventing debt levels or commodity prices from turning into higher inflation trends, and ensuring fiscal discipline. Another way to say this is that the real neutral (or equilibrium) interest rate has been positive.
  • Lower rates over the past decade are more the exception than the rule with economies now reverting to historical norms; positive real rates stand to benefit investors in the long run.
  • Investors should adjust their market expectations and perceptions of rising rates, and could benefit from the behavioural coaching by advisers in uncertain times.

Setting real interest rates above the rate of inflation is key to ensuring fiscal discipline and keeping the economy on sound footing, according to Joe Davis, Vanguard’s Global Chief Economist speaking at events across Australia this week*.

Historically, cash rates have nearly always been set above the trend inflation range, implying a positive real neutral (or equilibrium) interest rate. The last decade however has seen an unusual low-rate environment, given a more depressed economic environment post-financial crisis, that is more the exception than the rule.

“We’re entering an era where short-term interest rates are above trend inflation on average and provide positive real returns; an era of ‘sound money’,” said Mr Davis.

“We know many Australians are feeling the pinch of interest rate rises on their cost of living and ability to service mortgages, but longer term for investors this higher rate era we are moving into isn’t ‘new’, it’s actually a return to a more normal environment, and shouldn’t necessarily be viewed as a negative. The last few years of near-zero rates were in part to accommodate exceptional events such as COVID-19, and while effective at the time, they’re unsustainable in the long-run.

“So, while rising rates might mean the end of ‘easy’ money for some, the return to ‘sound money’ is a clear positive for the global economy and for long-term investors. Real positive interest rates not only provide a solid foundation for returns on all asset classes, but also lead to higher economic growth, higher returns for savers, forces fiscal trade-offs and ensures production efficiencies – they are the firewall protecting us from future inflationary pressures”.

According to Vanguard’s 2023 economic and market outlook, Beating Back Inflation, while inflation has likely peaked in most markets, reducing price pressures tied to labour markets and wage growth will take longer. Central banks are therefore likely to continue their aggressive tightening cycle into 2023.

“Contrary to popular belief, secular forces such as demographics, debt levels and deglobalisation are not always accurate indicators of inflation - it’s the ratio of job openings to unemployment that’s the most powerful signal,” said Mr Davis.

“If the number of job openings is higher than the number of people unemployed, labour markets remain exceptionally tight and wage pressure remains. Until this ratio declines, central banks will not cut rates even in the face of weakening growth, because getting inflation under control is the most pressing objective.

“The North Star for economies – what keeps them on track – is the short-term interest rate that central banks set. Keeping this rate above the inflation line is the key to avoiding a high inflation world”.

Advice can help clients adjust to a higher rate era

Recent Vanguard research that sought to quantify the value of financial advice revealed that human-delivered advice significantly increased clients’ peace of mind, particularly in periods of economic uncertainty.

In a survey of more than 1,500 advised investors in the U.S., human advisers were found to increase investors’ financial peace of mind by 56 percentage points, delivering significant emotional value including behavioural coaching, confidence, and a sense of accomplishment.

“Traditional economics assumes people are rational but in reality, behavioural biases exist and we tend to have less self-control than we believe – so that’s where financial advisers can step in and help,” said Paulo Costa, Vanguard’s Senior Behavioural Economist.

“Advisers can harness the human element of financial advice and provide the emotional value clients most appreciate: coaching them through macroeconomic changes such as rising interest rates, keeping them on track to meet their investment goals, and being a trusted consultant”.

*Vanguard this week hosted its annual Adviser Roadshow, welcoming more than 1,400 advisers (over 10% of the Australian advice market) over five days across Perth, Adelaide, Melbourne, Sydney and Brisbane. This year’s roadshow explored effective ways advisers can coach their clients through this period of inflation and uncertainty, drawing on the research and insights from Vanguard’s experts in economics including Vanguard’s Global Chief Economist Joe Davis and Senior Behavioural Economist Paulo Costa.