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The impact of rising interest rates are already being felt, with the housing market in a tailspin and the economy at risk, as the RBA battles high inflation. But the rate hiking cycle is far from over.
Official interest rates rose by 25 basis points to 2.85% on Cup Day as the RBA board met in Sydney to find a way to stamp out rapid widespread price rises.
“Higher interest rates and higher inflation are putting pressure on the budgets of many households. Consumer confidence has also fallen and housing prices have been declining following the earlier large increases,” said the RBA Governer, Philip Lowe, in a statement.
“Working in the other direction, people are finding jobs, gaining more hours of work and receiving higher wages. Many households have also built up large financial buffers and the saving rate remains higher than it was before the pandemic.”
“The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that.”
Rates have risen extremely quickly, from 0.1% at the start of the year to 2.85% as of today. It’s the seventh consecutive rise in as many months, and they could rise further, as the RBA Board has indicated. It meets for the last time this year on December 6, where it is anticipated that rates will rise again.
Which predictions should we pay attention to? Talk is cheap but some people put their money where their mouth is, in interest rate futures markets. Those markets are predicting rates will rise until a peak in March 2023 at just over 3%. That sounds like a lot more rate hikes to come, but as the next chart shows, forecasts from not long ago were for even more aggressive rate rises. Recently expectations have become more muted and even hint at falling rates in the second half of 2023.
Inflation: The Old Enemy
Defeating inflation has been one of the big triumphs of economic policy in the last 30 years. Now, with fuel at over $2 a litre and $9 lettuces, that victory is at risk.
The word inflation refers to persistent, widespread price rises. High inflation is considered bad, not least because it erodes the buying power of savings. If you had $1000 in the bank a year ago, it now buys around 7% less thanks to our 7% inflation over the last year. Inflation hurts anyone with money saved up, like retirees (although it helps anyone with debt, because the real value of the debt gets smaller).
But the reason we fear inflation runs deeper than that. When inflation sets in, it changes inflation expectations. Anyone bargaining for wages demands a high percentage lift each year, and those higher costs flow through to higher prices, and we can get stuck in an inflationary spiral. Nobody gets better off, but prices keep rising. Then the only way to bring inflation back down is to really crunch the economy. The RBA’s hope is to get inflation back under control before inflation expectations move upwards permanently and without sending the economy into recession, a challenge that the governor has described as a “narrow path”.
Runaway Price Rises
The RBA’s job is to control inflation. It’s failing, as the next chart shows. Inflation has shot far above the target band of 2 to 3%.
Why does inflation happen?
A company will lift prices when they have more customers than they can supply. Think about a tradie whose phone is running off the hook. Suddenly he will add 10% (or more!) to all his quotes.
If lots of companies are in that situation, they all raise prices and we get widespread inflation. Then the RBA steps in, lifting interest rates. This has three main effects, all of which are about reducing the need for companies to raise prices:
1. Households have less money to spend because people have to put more money to their mortgage.
2. Businesses spend less because the cost of borrowing money is higher.
3. The “wealth effect”: when interest rates rise, house prices fall, people feel less wealthy and spend less.
You will notice one thing in common about the above: Making Aussies feel poorer so they spend less. Yes, fighting inflation is painful, which is why we want to keep it under control in the first place.There are a few other ways monetary policy works, which are also about generating less spending at Australian businesses.
4. People save more when interest rates are higher. If they’re saving more, they spend less.
5. The exchange rate rises when interest rates are higher, making imports cheaper and domestic goods more expensive by comparison. (This works in theory but at the moment most central banks are lifting interest rates. And some are hiking much faster than Australia, so our rate hikes probably only stop our dollar getting weaker, don’t actually make it stronger.)
6. When house prices fall, fewer houses change hands, and we spend less on real estate agents and conveyancers, removalists and furniture (moving house usually makes people buy new stuff.)
All six of these reduce the amount of money Australians are spending at domestic businesses. That’s not fun for anyone – it makes things feel tight for households and businesses alike.
Will it work? It will if the problem is the one I described above: that they “have more customers than they can supply”.
But of course, at the moment, a lot of inflation is about import prices. Putin has upset global markets for wheat and oil with his war, and prices are sky high. Crushing Australian household budgets under enormous mortgage repayments isn’t going to move the dial much on petrol prices, for example. So there’s reason to be skeptical of whether the RBA really can beat inflation back quickly even if they lift interest rates as fast as predicted.
The “narrow path” the RBA is on might actually be more of a tightrope walk.
Frequently Asked Questions (FAQs)
What is the cash rate expected to be in 2023?
It’s hard to predict exactly what the RBA will do—after all it was only a year ago that governor Philip Lowe was predicting that rates would not rise before 2024. However, many economists believe rates could rise to around the mid-3% range by early next year. Westpac, for example, predicts that we will reach an official cash rate peak of 3.6% by February.
What are the disadvantages of high interest rates?
Higher interest rates are essentially a blunt lever that the RBA pulls to dampen consumer spending and lower inflation. The downside of this is that as credit cards and mortgages become more expensive, people have less money to spend and some struggle to make ends meet. There is another risk to aggressive rate rises: that the central bank could inadvertently tip the economy into a recession.
What is the current cash rate in Australia?
2.85%. The cash rate started the year at .1% at the beginning of the year but has moved up considerably since then due to the RBA’s aggressive rate hikes.
What happens when rates rise?
When rates rise on variable mortgages in Australia, it means that people’s mortgage repayments increase and they have less money to spend on goods and services. This dampens consumer confidence and spending, which, ideally, takes the inflationary heat out of the economy.
What happens if rates are too high?
If the RBA hikes rates too quickly and too aggressively it will tip the economy into recession. At the moment, the RBA is attempting to take the heat out of the economy without causing widespread suffering and a full-blown cost-of-living crisis.
