The Interest Rate Peak Is Getting Peakier

The RBA hiked rates by a quarter percentage point at its June meeting, taking the cash rate to 4.1%. Concerns about inflation staying too high for too long was the key factor driving the rate rise. The higher-than-expected April CPI data was probably the most single important single piece of data.

A backdrop of stubbornly high global inflation has not helped. At the start of the year the thoughts were that the cash rate might rise by between one quarter to one half percentage points in 2023. The cash rate has already risen by one percentage point this year, and the RBA may not have finished yet.

RBA analysis indicates that the full impact of higher interest rates does not hit the economy until 12-18 months following the rate change. And there are obvious reasons in this economic cycle as to why there are delays in higher rates impacting the economy. These include the higher-than-normal proportion of fixed rate home loans, as well as the supply-chain problems and worker shortages resulting in longer-than-usual delays to meet customer demand (notably in residential construction).

Over the next 6-12 months a sizeable proportion of borrowers will have rolled over from fixed home loans to variable rates. While the focus has been on the ‘fixed-rate cliff’ the majority of borrowers are already paying higher mortgage rates. The rise in mortgage rates has not been as steep as the increase in cash rate reflecting tough competition in the mortgage lending market although anecdotally this is changing.

Supply-chain problems are less of an issue, with a fair chunk of the residential construction backlog to be completed over the next 6-12 months. Concerns about worker shortages will continue to decline although may remain a worry for many firms for another 1-2 years.

There are clear signs the economy is slowing. The leading economic indicator series for the economy is declining. Forward orders are growing at around their long-term average although that is well down from the pace seen this time last year. Building approvals point to a sharp slowing in residential construction next year. Household spending on discretionary items is weakening (such as spending at restaurants and cafes). Business and consumer inflation expectations data point to easing pricing pressures, albeit at a level above what is consistent with 2-3% inflation.

But the cash rate is going to peak above 4%

But the cash rate will peak higher than expected. Despite the increase in rates, house prices are on the rise again. This would concern the RBA as declining asset prices (including house prices) is one way that monetary policy impacts the economy. In some respects, the combination of factors that have created the rise in house prices is unique to the housing market. There has been a rebound in demand due to the pickup of population growth. When combined with the structural undersupply of housing that has led to a jump in rents, making owning a home more attractive option for some. The large build-up of saving over COVID and the reduction in house prices may have made it easier for some households to afford a house deposit.

International comparisons suggest that the Australian cash rate looks low. Financial Market expectations about the cash rate in the countries typically compared with Australia (the US, UK, Canada and New Zealand) suggests a peak between 4.75-5.5%. The shape of the Australian yield curve suggests that financial markets don’t think that monetary policy is as tight as in other economies. Interest rate differentials have played a big role in the relative weakness of the $A this year (or more particularly, the strength of the $US).

Finally, there has been debate as to how much the Federal Budget and the recent Minimum Wage Case will add to inflationary pressures in the economy. There was no significant financial market reaction post the release of the Budget. And both the Treasury and the RBA have stated they think that the Budget will if anything reduce recorded inflation.

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