If financial markets and the vast majority of economists are to be believed, the next move in official interest rates from the Reserve Bank of Australia (RBA) will be higher.
Presuming that view is correct — and there’s little to suggest that it won’t be — the questions that naturally comes next is when will they increase, and by how much.
And, more importantly, how will the economy cope?
Recent discussion by the RBA in relation to the neutral level for Australia’s cash rate — that where monetary policy is neither providing stimulus nor restraint — has dominated market chatter since the minutes of the bank’s July monetary policy meeting were released just over a week ago.
In the RBA’s opinion, Australia’s new nominal neutral level for the cash rate is now 3.5%, some 200 basis points above where the rate currently sits.
Coming soon after former RBA board member John Edwards suggested the cash rate could rise by as much as two percentage points to 3.5% over the next two years should the RBA’s forecasts for economic growth and inflation be right, the debate had an immediate impact on financial markets.
Suddenly, the prospect of a RBA rate hike was not just seen as something that could arrive by the end of next year or later, but potentially as soon as later this year or in early 2018, at least among some forecasters.
Financial markets certainly think the risk of an earlier tightening has increased, bringing forward the expected timing of a rate hike to the middle of 2018 despite an attempt from RBA deputy governor Guy Debelle to hose down expectations that a near-term rate increase was likely last Friday.
Rightly or wrongly, some now believe that the RBA is about to begin its first monetary policy tightening cycle since late 2009, starting the process of pushing the cash rate back towards 3.5%, the level deemed to be neutral for the Australian economy.
However, not everyone thinks that process will begin so soon, nor to the scale the RBA and other more hawkish commentators currently foresee.
Adam Boyton, chief economist at Deutsche Bank in Australia, is among that group.
In his opinion, just 100 basis points of tightening from the RBA, let alone 200, would see Australian household consumption — the largest part of the Australian economy at a little under 60% — slow to levels “part-way between a mid-cycle slowdown and a genuine recession“.
Investment bank economists don’t use this kind of phrasing lightly.
To explain the reasoning behind his call, Boyton has produced three excellent charts on what 100 basis points of rate hikes would do to the Australian consumer.
Here’s the first showing how much four rate hikes of 25 basis points delivered between the June quarter of 2018 and the December quarter of 2019 would increase the financial obligations of households as a percentage of their gross disposable income.
Boyton says his analysis does not account for any “out of cycle” rate increases — basically, banks increasing the prices of loans beyond whatever the RBA does to the cash rate. He also assumes that household income growth will run at 5.5% per annum — more than double its current rate — with credit growth of just 4% per annum, a relatively rosy scenario to what is being seen right now.
Even with those assumptions, Boyton says the subsequent increase in household financial obligations would still be enough to sink consumption levels, shown in the second chart below.
It overlays household financial obligations as a percentage of disposable household income against the annual percentage change in household consumption levels. The latter has been inverted to show the relationship between the two.
It doesn’t paint a pretty picture.
“The impact of 100bps of rate hikes over 2018 and 2019 would work to lower household consumption growth by around 1.5 percentage points,” says Boyton.
And, as the third and final chart reveals, that would result in a sharp slowdown in household consumption expenditure, an outcome that would almost certainly result in a sudden deceleration in the Australian economy, or worse.
It is, after all, the largest and most important piece in Australia’s GDP growth jigsaw puzzle.
Weaken that and it would almost certainly spell trouble for the Australian economy.
Given the impact on the household sector, Boyton says that it would be “brave” to hike interest rates as much as some commentators have suggested.
And, opposed the view of the RBA that Australia’s neutral cash rate is now around 3.5%, Boyton says that from a consumer perspective, that neutral level is more likely to be around 1.75%, just 25 basis points above where the cash rate currently sits.
Recent weakness in household consumption expenditure, even with the cash rates sitting at record lows, makes a strong case for Boyton’s view.
Nor is he alone in suggesting that the neutral level for the cash rate is significantly lower than what the RBA current suggests.
Bill Evans, looking at the last RBA tightening cycle of 2009 to 2011, also concurs that the neutral level for interest rates is now significantly lower.
“If mortgage rates increased by a further 200bps, the evidence of 2011 suggests that house prices would likely fall,” says Evans, adding that occurred with “only a 175 basis point increase in the cash rate” at the time.
Evans suggests that given recent history, a nominal cash rate of 3.5% would hardly qualify as a neutral stance.
“Falling house prices could be reasonably associated with a wealth and financial stability shock that would push an economy off any stable equilibrium,” he says.
Others such as Gareth Aird, senior economist at the Commonwealth Bank, also think the RBA’s assessment on the neutral cash rate level is looking a little aggressive.
“Our qualitative and quantitative analysis points to a neutral range of 2.5%-3.5% meaning a mid-point estimate of 3%,” says Aird.
“The analysis suggests that the RBA is faced with a relatively easy task if it needs to put the brakes on the economy at some point further down the road.
“It wouldn’t take a lot of tightening in policy to restore monetary policy to a neutral setting.”
And, as Boyton and Evans suggest, even a slight overshooting on tightening could, in their opinion, do untold damage to the Australian economy as a result.