The 3.5% (or 350 basis point) increase in the cash rate over the eleven months since rate hikes started in May last year now clearly surpasses all of the rate hiking cycles seen since 1990 and is the fastest tightening since the rise in the overnight cash rate from 10.6% to 18.2% between January 1988 and November 1989. Back then the RBA cash rate was not officially announced which may have reduced its initial effectiveness, short-term rates were very volatile and mortgage rates were more regulated then and “only” rose from 13.5% to 17%. See the second chart below. Of course, household debt as a share of income was only 68% back then whereas its now 188% so rates shouldn’t have to go up anywhere near as much as they did in the 1980s to slow spending and hence inflation.
Source: RBA, AMP
In raising rates again, the RBA noted: high services price inflation; the still tight labour market; the risk of a prices-wages spiral; and that its “priority is to return inflation to target” and it remains “resolute” in its determination to do this and “will do what is necessary” to achieve it.
However, reflecting the run of recent softer economic data the RBA was far more dovish than in its commentary seen over the last month in noting that: the monthly CPI indicator suggests inflation has peaked; growth has slowed; labour market conditions have eased; and there is a lower risk of a prices-wages spiral.
Consistent with this somewhat more balanced assessment, the RBA’s interest rate guidance remains hawkish, but it was weakened slightly from “the Board expects to increase interest rates further over the months ahead” following its February meeting, which had been interpreted by many as implying that it expects at least two more rate hikes ahead, to the somewhat softer guidance that “the Board expects that further tightening of monetary policy will be needed”. In other words, the RBA still expects to increase interest rates further but just one move could be interpreted as consistent with its guidance. What’s more a month ago it noted that “in assessing how much further interest rates need to increase…” but now its referred to “when and how much further interest rates need to increase…” with the insertion of “when” opening the door to a pause on rates.
A speech tomorrow by RBA Governor Lowe on “Inflation and Recent Economic Data” will no doubt shed more light on the RBA’s views.
Banks are likely to pass the RBA’s rate hike on in full to their variable rate customers. This will take variable mortgage rates to their highest levels since early 2012. So a decade’s worth of falling mortgage rates have been reversed in eleven months.
The rise in mortgage rates is now well above the 2.5% interest rate serviceability test that applied for borrowers until October last year and the 3% that applied from October last year. So many recent home borrowers from the 2020 to early 2022 will now be seeing rates above the levels their serviceability was assessed at when they took out their loan.
Source: RBA, Bloomberg, AMP
The latest interest rate hike when passed on to mortgage rates will mean that the amount a new buyer on average full-time earnings with a 20% deposit can pay for a home will have fallen 27% from what it was in April – see the Capacity to Pay line in the next chart. So the downwards pressure on property prices will continue for some time yet even if the RBA soon pauses the cash rate. Of course, the relationship between prices and capacity to pay is not perfect and there is a risk that rising underlying housing demand from the return of immigrants and low new listings will offset the impact of higher interest rates on property prices.
Source: RBA, CoreLogic, AMP
RBA guidance suggests that it expects at least one more rate hike ahead, so with rates having increased far more than we anticipated – partly because inflation and the labour market last year turned out stronger than expected – the risks still remain on the upside for interest rates.
However, we are strongly of the view that the RBA should now pause. Here are eight reasons why:
- Inflation is still too high and the jobs market remains very tight, but inflation and the jobs market are invariably the last indicators to turn down in an economic downturn. In particularly, we are concerned that the RBA overreacted to the December quarter CPI. Letting inflation and jobs data dominate in driving monetary policy is like driving a car using the rear-view mirror.
- Supply pressures, which on the RBA’s analysis in its last SOMP drove 50% or more of the rise in inflation in Australia, are now receding with global supply bottlenecks continuing to dissipate with sharply reduced delivery delays, lower freight costs and most commodity prices well off their highs.
- The impact on the key 25-45 year old household demographic from rate hikes and cost of living pressures is now horrendous. A variable rate borrower on an existing $600,000 mortgage will see roughly another $95 added to their monthly payment from today’s RBA hike which will take the total increase in their monthly payments since April to around $1200 a month. That’s an extra $14,500 a year which is a massive hit to household spending power. And roughly two thirds of the now one third of mortgaged households with fixed rates will see a doubling or more in their payments when their fixed term expires by the end of the year. Put simply household debt servicing payments are now pushing their highest level in more than a decade and a rise in the cash rate to 4.1% as many are forecasting will take household debt servicing payments to a record level in terms of household disposable income. This will result in a sharp slowing in consumer spending (if not contraction) which will sharply reduce corporate pricing power and hence inflation.
Source: ABS, BIS, AMP
- The run of recent data indicates that RBA rate hikes are getting traction with: weak jobs data; a plunge in consumer confidence back to recessionary lows; slower than expected wages growth; stagnant nominal retail sales since September (and falling retail sales in real terms); weaker than expected underlying December quarter GDP growth (absent net exports it would have gone backwards); and weaker than expected inflation in January. This is all against the backdrop of an ongoing plunge in building approvals and housing finance. Economic data can run hot and cold and seasonal adjustment issues may be playing a role but taken together the run of recent data suggests that demand is cooling and inflation has peaked.
- While the RBA and others have been referring to excess saving buffers built up through the pandemic as a support for consumer spending, relying on this may be dangerous. These are thought to be around $250bn-$300bn and are bigger relative to household income in Australia compared to many other economies and they are often cited as a reason for uncertainty about the outlook for consumer spending as they could support higher than expected consumer spending as the buffers are spent offsetting the drag from rate hikes. However, there are numerous complications with this. First, their estimation is very rough being the gap between actual savings through the pandemic compared to what it normally might have been – but the estimate of saving is messy as it’s just the residual from income after consumption and not actual measured savings. Second, the savings buffer is not really evident in bank deposits which are running roughly in line with their long-term trend (or just $44bn above it – see the next chart) – suggesting any excess saving is not intended for future spending but may have been used to reduce debt or invest including via superannuation (although there is not much evidence of the latter). And finally, while the excess savings may make life easier for households that used them to pay down debt, they appear to be substantially skewed towards older people who may not adjust their spending much anyway as they are more focussed on saving for retirement. Whereas for younger newer entrants to the property market buffers are likely to be far less significant or non-existent. For these reasons its dangerous to rely on the so-called buffers as a significant source of upside support for consumer spending in Australia.
Dec 2022 data shows approximate age breakdown. Source: ABS, AMP
- While several other central banks have rates well above those in Australia (ranging from 4% in the US to 4.75% in the US and NZ) this may not be appropriate for Australia. Compared to the US where 95% of mortgages are 30 year fixed rate loans Australian households are far more sensitive as two thirds of mortgages are variable rate and the one third on fixed rate loans are only short dated with two thirds of these resetting to much higher rates this year.
- The ABS monthly Inflation Indicator looks to have slowed after its December spike. This monthly indicator is very volatile and only contains around 70% of the quarterly CPI so should be interpreted with caution but it suggests that we may have seen the peak in inflation with the December spike looking like a bit of an aberration. Rent inflation is continuing to accelerate but there are signs of slowing price gains in holiday travel, new dwelling, garments, food, furnishings and fuel.
- There is no sign of a wages break out or a dangerous surge in inflation expectations.
In summary, there is a strong case for a pause in rate hikes given the evidence of slowing demand, improving supply side conditions, the increasing pain being born by mostly younger households with mortgages, the absence of a wages breakout and contained longer term inflation expectations. We are concerned that ongoing rate hikes risk unnecessarily plunge the economy into a recession. As such its time for the RBA to have a pause and we are assuming a pause at their April meeting.
While the risks are still on the upside for rates, our view remains that we are at or near the top and that by late this year or early next the RBA will start cutting rates.
