The RBA is on a knife-edge between recession and inflationJul 27, 2023
Monetary policy operates with a lag. The pain from increased interest rates is only now starting to really bite. However, the substantial increase in interest rates is reducing demand and thus bringing inflation down. While on the other hand, further interest rate increases add to the risk of a recession. It is time therefore to pause further increases in interest rates.
Last month the Reserve Bank (RBA) paused its monthly increases in interest rates. The minutes of the RBA Board meeting indicate that that decision could easily have gone the other way. So what should the RBA Board meeting decide at its next meeting in a week’s time?
The inflation outlook
The decision by the RBA Board at next week’s meeting is widely expected to be heavily influenced by the latest data on consumer prices. These show that CPI inflation is continuing to ease, with annual CPI inflation of 6.0 per cent in the June 2023 quarter, lower than the 7.0 per cent annual rise in the March 2023 quarter, and well below the peak of 7.8 per cent in the December 2022 quarter.
The RBA, however, focuses also on the trimmed mean annual inflation rate which removes the more erratic outlying price increases for some goods and services. And at 5.9 per cent this trimmed mean was also lower in the June quarter, compared to March 2023 quarter inflation of 6.6 per cent, and the peak in December 2022 quarter of 6.9 per cent.
While generally it is reassuring that inflation is coming down, a worrying aspect is that services inflation recorded it largest annual increase in the year to June since 2001, driven by a range of services including rents, restaurant meals, holiday travel and insurance. Thus, the fall in overall inflation is entirely driven by the easing of goods annual inflation which continued to ease from 7.6 per cent in the March quarter to 5.8 per cent in the latest June quarter.
How the RBA will judge these contrary trends in the inflation rates of goods and services respectively remains to be seen, but I will argue below that the balance of advantage lies with a further pause in interest rates.
Why the pause in interest rate increases should continue
In a previous article before last month’s RBA Board meeting I gave the following reasons why interest rates should be put on hold for the month of July see Pearls & Irritations, 1 July Why the RBA should pause interest rate increases.
First, monetary policy only operates with a lag, and I cited some evidence that borrowers purchasing power was starting to be reduced significantly, thus reducing aggregate demand in the economy.
Second, some of the major sources of higher inflation, such as energy costs, reflect overseas markets and would not readily respond to increases in Australian interest rates.
Third, I addressed the RBA’s fear that a wage-price spiral as experienced in the 1970s and 1980s might take off again if inflation is not brought down quickly. I argued, however, that a repeat of such a wage-price spiral is extremely unlikely. Labour markets are very different today, and the RBA’s failure to understand that is evident from their excessively high forecasts for wage growth over the last decade or more.
My reason for now suggesting that the interest rate pause should continue is first the later data (referred to above) means we can be a bit more confident that inflation is coming down. But second, and perhaps more importantly I want to consider additional evidence about the impact of the lags inherent in monetary policy and how the previous interest rate increases are now starting to bite quite strongly.
How are householders faring?
Essentially the authorities’ expectation is that an increase in interest rates will bring down consumer and investment demand over time, and it is this reduction in demand that is expected to eventually result in lower inflation.
Furthermore, this reduction in demand is mainly achieved by increasing the cost of housing for people with a mortgage or who are renting, and for whom housing is typically their biggest expense. Thus, if the cost of their housing increases dramatically they find that they have to cut back on other expenses, as often the cost of their housing is immutable unless they are prepared to move to less expensive (and less satisfactory) alternative accommodation.
This burden of increased housing costs is widely felt as approximately one third of Australia’s housing stock is owned by people paying off their mortgage, another third is occupied by tenants, and the remaining third is owned outright by their occupants. It is the first two groups who are affected by rising interest rates, whereas the people who own their home outright are relatively well off and largely unaffected by rising interest rates – indeed, they may even gain with higher returns on their savings.
But this reduction in demand by mortgagees and to a lesser extent by tenants only operates with a lag. In Australia, a key reason for this lag is that many borrowers fixed their interest rates on their home mortgages when interest rates were at historically low levels before the RBA moved to increase them starting in May last year.
According to RBA research “During the COVID-19 pandemic, the value of fixed-rate housing loans increased substantially, peaking at almost 40 per cent of outstanding housing credit in early 2022, or roughly twice their usual share prior to 2020.”
That in turn has meant that many mortgages have not been affected by the increase in interest rates so far. But that postponement of increased interest payments is starting to change as the fixed rate mortgages are reviewed by the banks after a year or two.
Again, according to the RBA, “One quarter of fixed rate loans outstanding in early 2022 [just before interest rates started rising] have now expired; most have rolled on to a variable rate loan, rather than re-fixing at a higher rate.” In addition, “Another 40 per cent of fixed-rate loans outstanding in early 2022 will expire by the end of 2023.”
Thus, the pain from increased interest rates is only now starting to really bite, and it will bite very hard over the current half year. For example, for those home-owners with a fixed rate mortgage, the median mortgage is around $600,000, and as they switch to a variable rate mortgage their repayments increase by more than $300 per week. That represents about a quarter of the median wage and will have a huge impact on their cost of living and what else they can afford to buy.
Of course, as already noted, that leaves about 60 per cent of homeowners with a mortgage who did not take out a fixed rate loan and were therefore more immediately affected as interest rates started to rise. But again, many of these borrowers were also able to postpone the pain as they took advantage when interest rates were low to get ahead in their mortgage repayments.
These variable rate borrowers can draw down on their offset accounts until the accounts are exhausted and they have thus been able to postpone the impact of rising interest rates on their living standards. However, these savings are now close to being used up and the pain of increased interest rates will increasingly bite for them as well.
In sum, the RBA research estimates that after rolling off, roughly 25 per cent of fixed rate borrowers would need to spend more than 30 per cent of their income on loan repayments, and almost as large a share of variable-rate borrowers would be similarly affected. In addition, these borrowers are disproportionately in the bottom half of the income distribution, and we can expect that they will have to reduce their consumption substantially.
As for renters, according to the data source CoreLogic, monthly median rent values have increased $225 per month over the year to June. However, mortgage costs of a new investment loan are estimated to have increased by $948 per month on the median Australian dwelling value.
Further increases in rents can therefore be expected as the landlords continue to adjust to these higher mortgage repayments. Although it is unlikely that rents will increase by enough to cover the full extent of investors’ increased mortgage repayments as negative gearing by the investors has long been common.
But even so, we know that significant numbers of renters are already feeling the pain. A recent survey of almost 750 people by the community group, Everybody’s Home, found that 82.5 per cent of renters are in rental stress, paying more than one third of their income in rent.
Finally, there is increasing evidence that consumers are now starting to respond to the increased cost of housing by reducing their demand for other goods and services.
Unfortunately, the available data are for the March quarter, but they show even back then, household spending only increased by 0.2 per cent, the weakest quarterly result since the fall recorded during the Covid lockdowns in September 2021.
Spending on essential goods and services increased by 1.1 per cent, led by electricity, gas and other fuel (up by 5.2 per cent), but discretionary spending fell by 1.0 per cent. Even the increase in essential spending was held up by a decline in the household saving ratio from 4.4 per cent to 3.7 per cent, the lowest level since June 2008. Thus, people have been drawing down on their savings to sustain their consumption, but that is a diminishing possibility.
Demand is likely to have weakened further since March, and the pain from increasing interest rates is continuing to rise and will get worse, even if interest rates stop increasing. As the RBA Board concluded at its last meeting: “mortgage interest payments (as a share of disposable income) were around a record high in May and would rise further as fixed-rate loans continued to mature, even if the cash rate was not increased further.” The Board then went on to conclude “that the full effects of the policy tightening that had occurred over the previous year were yet to be observed.”
In sum, monetary policy operates with a lag, and it is only now that the pain from interest rates is starting to really bite. But the size of that bite and its likely impact on demand, means that the RBA can afford to wait longer to assess whether interest rates need to increase any further at all.
As the Governor has insisted the RBA is trying to stay on a very narrow path between producing a recession and bringing inflation down. Given the extent of the interest rate increases so far, it is likely that they will bite even more heavily in the near future, and the prudent course would be to leave any further increases on hold for a while.