Dr Shane Oliver, Head of Investment Strategy & Chief Economist at AMP, discusses the RBA’s cash rate hike.

Key points:

The RBA raised the cash rate by 0.5% taking it to 2.35%, as widely expected.This is the fifth rate hike in a row, and the fourth 0.5% hike in a row and brings the total increase in rates to 2.25% since April.Given “long and variable” lags in the way monetary tightening impacts the economy there is a strong case for the RBA to now slow the pace of rate hikes in order to better assess their impact so far. Failure to do so risks recession and overkill in taming inflation.We expect the RBA to so slow the pace of hikes in the months ahead and will watch Governor Lowe’s speech on Thursday for any guidance in this direction, but its looking like our assessment for the cash rate to peak at 2.6% around year end is now too conservative so we have revised it up to 2.85%.We continue to see the RBA starting to cut the cash rate in the second half of 2023.Market expectations for the cash rate to peak around 3.8% in the September quarter next year look too hawkish and if realised would likely plunge the economy into recession and push home prices down by 30% or so from their highs earlier this year.In justifying another 0.5% hike the RBA: reiterated that inflation is the highest it’s been since the early 1990s and set to rise further with strong demand and a tight labour market playing a role; the labour market remains tight, wages growth has picked up and in some areas labour costs are increasing briskly; and it is important that medium term inflation expectations remain “well anchored”. The RBA reiterated that it expects inflation to rise to 7.75% by year end, before falling in the 2023 and 2024.

The RBA’s rapid rate hikes reflect a desire to bring demand back into line with constrained supply and to contain inflation expectations by reinforcing its commitment to its inflation target.

This is the fastest increase in rates since a total increase of 2.75% over five months from August to December 1994. The speed of the rate hikes compared to the last three tightening cycles reflects the extent of the blow out in inflation and the low starting point for the cash rate.

Source: RBA, AMP

The RBA’s commentary remained hawkish reiterating that it will “do what is necessary” to return inflation to target and it indicated that it expects to raise “interest rates further over the months ahead”.

Banks are likely to pass the RBA’s rate hike on in full to their variable rate customers and deposit rates will rise further. This will take variable mortgage rates to their highest levels since 2012.

This may not have hit spending much yet, but it will in the months ahead. As Milton Friedman long ago observed the lag from a change in monetary policy to its impact on the economy is “long and variable.” 

Source: RBA, Bloomberg, AMP

Given the blow out in inflation the RBA has been right to act aggressively to slow demand back to be more in line with supply and to signal its commitment to get inflation back to its 2-3% target as this will help keep inflation expectations down. The experience of the 1970s and early 1980s highlights the importance of keeping inflation expectations low. And the RBA is right to point out that “price stability is a prerequisite for a strong economy and a sustained period of full employment”.

So far the jobs market remains tight and consumer spending remains strong. However, based on the experience in the late 1980s ahead of the early 1990s recession this is not particularly surprising and its only a matter of time before spending starts to slow. As such the RBA needs to start treading more carefully.

Money market expectations for a cash rate of around 3.8% are still too hawkish and there is a strong case to slow down the pace of rate hikes

We remain of the view that the cash rate won’t have to go well above 3% before the RBA achieves its aim of cooling demand enough to take pressure off inflation and keep inflation expectations down.

First, global supply bottlenecks are continuing to show signs of improvement with reduced delivery delays, lower freight costs and falling metal and grain prices.Second, while energy prices are likely to remain high, they may be getting close to their peak so their contribution to ongoing inflation may go to zero later this year.Third, many households will experience a significant amount of pain from higher rates. For example, a variable rate borrower on an existing $500,000 mortgage will see roughly another $140 added to their monthly payment from today’s RBA hike which will take the total increase in their monthly payments since April to nearly $650 a month. That’s $7800 a year which is already a massive hit to household spending power. And there is roughly a quarter of mortgaged households with fixed rates who will see a doubling or more in their payments when their fixed term expires over the next two years.Finally, while coincident and lagging indicators of the economy like retail sales and jobs data are still strong, leading indicators tell us the RBA is getting traction – consumer confidence is at recessionary levels, housing indicators are falling sharply and home prices are now also falling sharply which will depress consumer spending via a negative wealth effect.

Source: Westpac/MI, AMP

So given the significant monetary policy tightening already seen, the reality that this will only hit the economy with a lag as it takes a few months for rate hikes to be passed on to borrowers and then for borrowers to adjust their spending, the big hit from falling real wages and the increasing weakness in leading indicators notably for consumer confidence and housing there is a strong case for the RBA to slow the pace of tightening to give more time to assess its impact so far.

Given the lags involved and the slump already evident in leading indicators a failure by the RBA to slow the pace of tightening and to raise the cash rate towards 4% as the money market is assuming would risk recession and overkill in taming inflation.

Fortunately, while the RBA’s guidance on rates remains hawkish it is indicating an awareness of these issues – with its comment that “higher interest rates are yet to be fully felt in mortgage payments” and its awareness of falling confidence and home prices. Along with its desire to “keep the economy on an even keel” and that “it is not on a pre-set path” it suggests that it may be moving towards some slowing in the pace of hikes in the months ahead. Governor Lowe’s speech on Thursday will be watched closely for any signs of this.

However, its looking like our assessment that the cash rate will peak around 2.6% around year end is too dovish and so we have revised it to 2.85% (with 0.25% hikes pencilled in for October and December), albeit the risk is still on the upside. We continue to expect rate cuts towards the end of next year though.

We continue to see average home prices falling 15-20% top to bottom and this is occurring earlier and faster than previously expected. A rise in the cash rate towards 4% as the money market is assuming would likely result in steeper falls in home prices. 

Ends

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