Why the RBA Can’t Be Too Aggressive

Australia | Sep 21 2022

With Australians heavily exposed to variable rate mortgages, the RBA has to tread more carefully than the Fed, despite a still-solid consumer outlook.

-Australian fixed mortgages low in number and short in duration compared to the US
-RBA wary of putting more pressure on struggling households
-Australian consumer still positive, if they can afford it

By Greg Peel

With Fed chair Jerome Powell laying down the law at August’s Jackson Hole symposium, Wall Street is expecting at least another 75 point rate hike tonight.

By contrast, RBA governor Philip Lowe suggested recently "the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises" – a comment backed up in the minutes of the September policy meeting.

While this is fairly obvious, the fact he said it suggested a slightly more dovish tone to the RBA than the Fed, and on the day sent the local market surging.

Those minutes, released yesterday, noted the RBA did consider only a 25 point rate hike before settling on 50.

Yet the RBA is forecasting the Australian CPI to rise to 7.75% by year-end, from 6.1% in the June quarter, while in the US the signs are inflation has peaked and should start to come down, albeit slowly. Why then is the RBA seemingly more dovish than the Fed?

The difference lies in the impact of monetary policy on households in the two countries, suggests Jarden.

In the US, the pass-through of monetary policy to the real economy is primarily through “financial conditions” (the stock market and corporate credit spreads), Jarden notes, with the direct impact on households relatively limited. In the US, some 95% of mortgages are fixed for 15-30 years.

Thus while borrowers may have looked aghast when the standard 30-year US mortgage rate recently rose above 6%, the impact is only felt by those looking to buy a home or refinance their mortgage, not on existing mortgages.

By contrast, fixed-rate mortgages in Australia are typically only of 1-5 year in duration, and the share of fixed mortgages, as opposed to standard variable rate mortgages, is typically around only 10-12%.

Jarden currently estimates that number to be around a third, given Australian banks panicked during the pandemic and dropped their fixed rates on offer to below their SVRs in order to grow their loan books – to as low as less than 2% — and drew a substantial refinancing push. But still, this means an estimated 80% are exposed to higher rates within a year.

Hence the RBA is wary of taking its cash rate too high.

Jarden is estimating a “terminal” cash rate (where the RBA will stop) of 3.1% (rate currently 2.35%), well above the RBA’s assumed “neutral” rate (balance between stimulatory and restrictive) of 2.5%. Restriction is required to bring inflation down.

However, Jarden estimates the neutral rate is currently 1.5%, not 2.5%, hence it is unlikely an RBA rate above 3% can be maintained for too long. Jarden’s economists thus expect 25 point rate hikes at the next three meetings, although would not be surprised by another 50 pointer next month.

Most economists expect 50 points next month, but the September minutes have now led to some doubt.

Stressful

New research from Roy Morgan shows an estimated 854,000 Australian mortgage holders (19.4%) were “At Risk” of “mortgage stress” in the three months to July 2022. This period encompassed the first three interest rate increases from the RBA in May (25 points) June (50) and July (50) with the cash rate hitting 1.35%.

Mortgage holders are considered “At Risk” if their mortgage repayments are greater than a certain percentage of household income – depending on income and spending.

Mortgage holders are considered “Extremely at Risk” if even the “interest only” is over a certain proportion of household income.

The good news is the proportion of mortgage holders considered “At Risk” of mortgage stress in mid-2022 is well below the high reached during the GFC in early 2009 of 35.6% (1,455,000 mortgage holders) and below the average of the last decade of 20.8% (904,000).

There has been a similar trend for mortgage holders considered “Extremely At Risk”, with only 12.7%, or 542,000, in this group in the three months to July 2022, below the average of the last decade of 13.9% (585,000 mortgage holders).

The bad news is the RBA has since hiked rates by 50 points in each of August and September, taking the cash rate to 2.35%.

If the RBA increases interest rates by 50 points in each of the next two months, Roy Morgan estimates this would mean 24.3% of mortgage holders, 1,100,000, would then be classified as “At Risk” – an increase of 246,000 on July 2022. This would be the most mortgage holders classified as “At Risk” since July 2013.

That said…

Goldman Sachs notes elevated inflation has eroded real income growth across the globe and led to a drop in consumer confidence.

Real spending growth (meaning: adjusted for inflation) has slowed substantially in North America and Europe, but remains solid in Japan and Australia, given later covid re-openings and less-elevated inflation.

On the positive side, notes Goldman, tight labour markets mean unemployment rates remain very low across all developed economies, and household balance sheets also remain strong given high levels of savings during lockdowns. Debt servicing ratios (to income) also remain low due to years of low interest rates.

Comparing economies, Goldman Sachs rates “consumer health”, on a scale of 0-100, as 35 in the UK and Europe, 40 in the US, 50 in Canada and 60 in Japan and Australia.

But if the RBA hikes a further 75 points (to 3.10%), SVR mortgage rates rise in concert, inflation rises to 7.75% (noting the fuel excise holiday is set to end), can Australian consumer health continue to be above other economies, particularly given the above?

The Wealth Gap

The most asked question of UBS equity strategists this year has been “for how much longer can the Australian consumer keep spending?”

After surveying 1000 Australian consumers between August 15 and 29, UBS found consumers are still positive despite higher rates and cost of living. Through a period where the RBA had enacted multiple interest rate hikes, the survey’s results showed spending is still expected to accelerate over the next 12 months.

But which consumers?

The survey pointed toward record levels of positive sentiment from high-income earners (greater than $120k), who recorded a significant increase in their spending intentions. They were also the group, UBS notes, that is now on the clearest upward trend in terms of income growth, savings, debt intentions, home purchases, home renovations, travel, and vehicle spending.

The story is not the same for low income earners (less than $48k).

Cost of living pressures are forcing consumers to spend more on essentials, with food, fuel, utility and healthcare costs impacting most.

Clearly this disproportionately hurts lower- income earners, whose daily needs spending represents a much higher ratio of the household budget. By contrast, the tight economy shines positively, UBS suggests, on higher-income groups due to the wage gains they are experiencing and their ownership of capital (property, stocks etc).

Given a high level of savings, consumers still want to spend on post-covid travel and 56% of those surveyed said they would draw down on savings to do so. While falling house prices have dented the “wealth effect” which supports spending, consumers continue to cite high levels of income stability and job security as the key positive supports behind their financial outlook, UBS notes.

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