June 2022

Going into the May RBA Board meeting, economists thought the three possible scenarios were possible: no move, a 0.15 rise or a 0.4 percentage point hike. Financial Markets were fully priced for a 0.15 percentage point move. By moving by 0.25 percentage points (to 0.35%) the RBA obviously wanted to do something different for its first move in over one year.

The reason given why interest rates have gone up is what you would expect: the economy is doing so well that it doesn’t need more help, and inflation is rising strongly. The RBA appears comfortable about the economic growth outlook, although they acknowledge the various risks (China and COVID, Russia-Ukraine the impact of higher inflation). The RBA is forecasting that the unemployment rate will decline to 3.5% by early next year and remain there. The RBA suggested that much of the recent rise in inflation has been down to global factors, although they noted that domestic factors are playing an increasing role.

A further rise in the annual inflation rate is expected over the next 3-6 months (although I think the largest quarterly rise may have already happened). Inflation is then expected to moderate, with 3% the forecast by mid-2024. Using as evidence their liaison program and business surveys, the RBA feels confident that wage growth is rising, despite it not yet being evident in the economy-wide data.

Demand is expected to remain strong, but there is greater uncertainty about supply

It is hard to argue that the cash rate should be at 0.1%. Inflation is at its highest level in over two decades, and the unemployment rate is at its lowest level in almost five decades. I had thought they might have delayed moving until June until stronger wages growth was more evident. But the RBA clearly had decided it has seen enough evidence on that front.

Higher interest rates work by reducing demand. Higher interest rates reduce the incentive to borrow, as well as reduce the cash flow of existing borrowers. They can reduce asset prices (such as house and equity prices) and encourage households to increase savings. It can also result in a higher exchange rate.

The uncertainties on the demand side are how much will consumers spend as they face declining real wages growth (wages growth less than inflation) and higher interest rates given the level of household debt. The evidence to date is that consumers in the aggregate are still spending, although some households are starting to find the going tough. How that evolves will play an important role in terms of how high and how fast interest rates will rise over the next year.

The cash rate is not the only financial variable that moves the economy

Much of the focus is on the cash rate. But other variables can also have a strong influence on the economy. The cash rate typically has a significant impact on the variable mortgage rate. But fixed mortgage rates are driven more by financial market views of future cash rate movements. And with financial markets now expecting significant rises in the cash rate over the next couple of years, there has been a notable jump in fixed mortgage rates over the past couple of months (particularly longer than 3 years’).

Movements in asset prices (such as housing prices and equity markets) can also influence the economy. House price growth has moderated noticeably in recent months, partly reflecting rising fixed mortgage rates. The rising number of homes for sale and affordability concerns though have probably played a bigger role. Worries about rising global interest rates have certainly played a role in the recent weakness of equity markets.

What history tells us about this interest rate cycle

In the four monetary policy tightening cycles in Australia (and the US), the cash rates rose between 1.50 to 3.25 percentage points. So the amount of tightening currently priced in by financial markets is higher than each of the preceding four tightening cycles. The starting cash rate is (substantially) lower.

Three of the previous cash rate cycles were short (5-13 months). The other cycle was substantially longer, reflecting the surprising strength and duration of the largest mining boom in Australia’s history as well as a global credit boom in financial markets (that resulted in the GFC).

The cash rate is heading higher. And so it should. The big questions from here are how high does the cash rate head in this cycle and how quickly will it get there. Financial markets appear to be pricing an aggressive amount of rate increases in this cycle compared with previous occasions. The higher than expected move at the May meeting will only add to financial market confidence about their views about the size and pace of future RBA moves.

Given the inflation outlook and extremely low level of the cash rate, financial markets could be right. I think in time the cash rate could hit 3%. But virtually all economists and the history of the past thirty years say that the pace of cash rate rises in this cycle appears too quick and probably too high. Time will tell who is right.