Monetary mavens seek cover

Leon Gettler

All focus in the week and months ahead will be on the Reserve Bank of Australia and interest rates. 

With inflation rising globally, pressure is now on central banks around the world to raise cash rates, and the spotlight is burning brightly on the Reserve Bank of Australia. The era of cheap money is coming to an end, signalling pressure on businesses and mortgage defaults.

The US Federal Reserve has pencilled March in for its first rate hike since 2018 when it is likely to begin with a quarter-point move. Federal Reserve chair Jerome Powell has left the door open to going harder on rates than in the last tightening cycle. This is significant because the question the Fed was asking during 2021 was whether emerging inflation was transitory, basically due to the pandemic, or whether it was more structural. 

In his recent press conference, Powell said the “committee is of a mind to raise the federal funds rate at the March meeting, assuming that the conditions are appropriate for doing so”. 

He highlighted a much stronger labour market and much higher inflation facing officials this time around. Powell and the Fed are confronting 7 per cent inflation, the highest since 1982. Powell said December’s inflation was worse than expected and said the US faces a much different economic situation than its last rate-hiking cycle when inflation was running at about 2 per cent. 

Economists expect a quarter point rise in the Fed Funds rate in March although Nomura has changed its call and has forecast a 50 point rise. If the Fed sees that it is behind the curve, the Fed is likely to opt for a “shock and awe” approach with a hike at every meeting. Bloomberg Economics has forecast the year will probably end with a total of five hikes, and has flagged an upside risk for six.

The pressure is also on the Bank of England which has bet on inflation peaking at 6 per cent.
Actions by the Federal Reserve and the Bank of England will put pressure on the RBA.  

In Australia, the RBA’s line that interest rates won’t shift until 2024 is now looking unlikely with the Consumer Price Index figures showing prices over 2021 rose 3.5 per cent with the RBA’s trimmed mean rising by 2.6 per cent over the past year – in the middle of it’s target range of 2-3 per cent inflation.

The trimmed mean is what the RBA tends to focus on. Added to that is this month’s jobless figures showing unemployment sinking to 4.2 per cent, the lowest level since 2008.

But while inflation is now in the RBA’s target band, a closer examination of the CPI figures show they have been shaped by the pandemic. RBA governor Phillip Lowe in November 2021 maintained that the pandemic had prevented households spending on services such as holidays, cinemas and restaurants.

Consumers were isolating and staying safe and had therefore switched to spending more on goods. This exacerbated the pressures on supply chains (already affected by workers being sick or confined to home) and bid up some prices on goods.

Lowe said these effects were likely to be temporary. The latest CPI numbers seem to reflect his views. The price of services grew by 2.3 per cent, while goods rose by 4.3 per cent. Inflation might decline once supply chains are operating more normally.

But the outlook for inflation is complicated. The supply chain problems and the Omicron outbreak has lowered consumer confidence but that might be temporary with signs that the pandemic is peaking and hospitalisations falling. 

At the same time, the 4.2 per cent unemployment rate is not translating at this stage into wages growth with average wages in the 12 months to September 2021 (the latest data) growing by just 2.2 per cent.

The inflationary pressures from rising wages in the US has led the Fed to foreshadow raising cash rates. But things are different here. As Lowe said in November: “It is likely wages will need to be growing at 3 point something per cent to sustain inflation around the middle of the target band”.

Which is why the RBA is likely to hold off on a rate rise for now and take time to see whether the inflation is temporary or structural, with wages contributing to price rises.

The bond market is expecting a rate hike in June (that is, not before the election), but AMP Capital chief economist Shane Oliver is now expecting to see interest rates increase by 0.15 per cent in August. 

Westpac chief economist Bill Evans also expects a 0.15 percentage point rise in August, followed by another 0.25-percentage-point increase in October. 

He says the wages outlook will “change quickly by the middle of 2022”. This will see it rise faster than previous RBA forecasts, and put further pressure on inflation. 

If prices and wages pick up faster in Australia like the rest of the world, economists are suggesting interest rates would need to rise sooner than the late 2023 or 2024 timetable the RBA has previously signalled. Westpac expects the cycle of rate hikes will end in early 2024 and it is expecting the cash rate to rise from 0.1 per cent to a peak of 1.75 per cent.

It is worth pointing out that the pressures on the RBA are nothing like those facing the Fed. Inflation in Australia is right in the middle of the target band, not way outside it as in the US. The Fed cannot wait and it needs a “shock and awe” strategy to pull inflation into line. The RBA has time to assess how inflation is playing out, whether it’s transitory created by COVID-induced supply chain problems, before pulling the trigger on increasing interest rates.

Nonetheless, if rates do increase in Australia, it will put pressure on households and business with some forecasting that a rate increase will see 0.5 per cent increase in mortgage defaults. This is exacerbated by excessive debt levels. 

March 2021 figures provided by the RBA show household debt-to-disposable income ratios hit 180.9 per cent, tapering off from the highs of 188.5 per cent seen in June 2020. 

According to the Bank for International Settlements, household debt in Australia decreased to 120.50 per cent of GDP in the second quarter of 2021 from 123.40 per cent of GDP in the first quarter of 2021. However, with slow income and wages growth, this would put pressure on households facing interest rate hikes. 

APRA data shows almost a quarter of new mortgages issued during the September quarter were considered risky. APRA found 23.8 per cent of mortgages approved in the three months to September had a debt ratio of at least six times the annual income of the person or people paying it off. Australian government debt is approaching A$1 trillion.

Economist Saul Eslake said the government will not have trouble servicing its debt even if interest rates were higher and corporates don’t have as much debt relative to the size of the economy or their revenues as they did towards the end of the 1980s.

“But Australian households are amongst the most indebted in the world,” Eslake said. “Most of that debt is at floating rates so the cost of servicing it does respond quite quickly to movements in the official cash rate unlike the United States where most mortgage debt is fixed for 30 years and the Reserve Bank will have to tread very carefully as it seeks to return interest rates gradually to more normal settings.”

Eslake said the RBA has a communications problem.

“I don’t doubt the governor of the Reserve Bank would say he never made a promise that rates wouldn’t go up until 2024. You could forgive the average borrower for thinking that’s what he’s done. Although towards the end of last year the Reserve Bank backed away from its insistence that it wouldn’t be raising rates until 2024, it was saying it wouldn’t be raising rates in 2022, or I think that’s how most of the public interpreted their statements,” Eslake said.

Whether a rate rise affects the stock markets, households, housing, consumer and business confidence and the real estate market remains to be seen. At this stage, property developers are not worried. 

Danny Avidan, founder and director of the DARE property group said the market will continue to be strong particularly at the upper end, regardless of how interest rates travel.

He said the uncertainty that comes with speculation of rate rises will not last long as the rises will not be substantial and they are unlikely to affect the premium end or middle market. 

“There is a whole lot of media hype about interest rates going up which is creating some uncertainty with purchases but that won’t last long because at the end of the day, even if interest rates go up from the middle of next year, if you are looking at a $1 million mortgage and add 1 per cent to it, it’s $10,000 and it’s not the end of the world,” Avidan said.

Andrew Schwartz, group managing director and co-founder of real estate investment management firm Qualitas, said the RBA raising interest rates was generally a function of an economy doing well. He said with the modest size of the interest rate increases and the significant buffers that the banks had in place, borrower insolvency and mortgage distress were unlikely.

Nor did he accept predications from some economists that a rate rise would send force down property values.

Nonetheless, the markets, business and households will watch carefully to see whether these forecasts for the impact of interest rate rises in 2022 will come true.