Here's why the RBA has a tricky road ahead in raising interest rates

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  • Research from the Bank of International Settlements suggests rising household debt has a negative economic impact over a 3-5 year timeframe.
  • Australia’s household debt-to-GDP ratio peaked in 2016, so the negative lag effect may be felt most keenly over the next two years.
  • It means the RBA will have to exercise extra caution in raising interest rates.
  • On a more positive note, with house prices now cooling Australia’s household debt should also start to stabilise.

The challenges posed by Australia’s high level of household debt will be felt most acutely by policy makers over the next two years, according to Nikko Asset Management.

Nikko’s fixed income strategist Chris Rands said that in such an environment, “interest rate hikes could be more contractionary than cuts are expansionary, and will require the RBA to be more cautious than in prior cycles”.

“As such, a key cost of high household debt is that it reduces the ability for central banks to conduct effective monetary policy.”

Rands based his analysis on 2017 research from the Bank of International Settlements (BIS), which describes how increases in household debt have a lag effect on economic growth.

The BIS found that an increase in the ratio of household debt-to-GDP often provides a short-term economic boost, but those positive effects are reversed over a three-to-five year time frame.

“One explanation for these findings is that the benefits of household debt are front loaded in the first two years of borrowing, as the proceeds are used to increase consumption,” Rands said.

“The downside, however, is that this consumption cannot be repeated in later years and will be lower than otherwise would have occurred as households service their debt.”

And the findings are particularly relevant to the domestic economy, given that Australia’s debt-to-GDP ratio peaked in 2016 at more than 125%.

Following a small decline, the ratio remains around 120% and is the second highest in the world behind Switzerland:

Nikko Asset Management

“If household debt truly peaked in 2016, this implies that the higher debt ratios will begin to take effect and slow potential growth from 2019 onwards, coinciding with the timeline of debt effecting growth 3 to 5 years in the future,” Rands said.

He notes that in the period from 2013-2015, Australian household debt steadily rose and consumption also increased amid a backdrop of rising house prices — particularly in Sydney and Melbourne.

“This helped the economy grow through a tough period when the commodity sector was performing poorly,” Rands said.

“The side effect of this boost to consumption, however, is that the household debt-to-GDP ratio increased 10%.”

In view of that, the BIS research — which found that every 1% gain in debt-to-GDP creates a 0.1% drag on GDP over a five-year time frame — makes for more sobering reading.

“If this relationship holds true for Australia, it would mean that the boost to consumption achieved in this period will come at the cost of 1% lower growth in the future,” Rands said.

“A drag of this magnitude would make it harder for the Australian economy to achieve 3–4% growth, which the RBA has repeatedly forecasted in their monetary policy statements.”

Based on this measure, it’s perhaps not surprising that analysts have been extending their time frames for the next RBA rate hike.

And in the minutes to its February meeting released this morning, the RBA noted markets now expect no change to the official cash rate in 2018, with a 25 basis point increase now priced in for early 2019.

The second challenge Rand highlighted is that high household debt also reduces the capacity of mortgage-holders to respond to unexpected negative shocks.

And in recent years, Australian households have addressed that challenge by drawing down their savings amid an extended period of low wage growth.

Nikko Asset Management

“Usually in this environment, households could increase borrowing to smooth their consumption,” Rands said.

“But the RBA is reticent to encourage this behaviour given the high household debt ratios.”

So Rands said that domestic consumption is likely to remain compressed unless there’s a noticeable rise in disposable income, now that Australian house prices are falling.

In that context it’s no surprise that the outlook for wage growth in Australia — with wages data for the December quarter scheduled for release tomorrow — has taken on increased significance for policy makers.

“The positive side of this outlook is that future growth should not continue to be eroded away, as household debt should stabilise with house prices,” Rand said.

Similar sentiments were recently offered by JP Morgan analysts, who said it would be “good for the system” if Sydney and Melbourne house prices rise at a slower rate than nominal GDP “for a number of years”.

Amid that backdrop, Rands concluded that “the RBA will need to be relatively cautious when they are ready to start an interest rate hiking cycle, as large declines in property prices and household debt will be problematic for the economy”.

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