Interest rate expectations have changed - we explain why

This in an environment in which Australia’s population growth is at multi decade highs driven by surging migration.

Yet rising interest rates combined with wage and cost inflation is not conducive to encouraging builders to increase commencements. Housing starts are at their lowest ebb in more than a decade. 

Inflation within the services sector is also problematic. Health, education and insurance inflation are each stubbornly high and above the RBA’s target inflation range. Transport is also above the RBA target band, albeit it is a composite of the cost of motor vehicles, fuel, transport services and spare parts for motor vehicles.

In fact, if we split inflation into goods inflation and services inflation, the latter is currently 4.2% and rising.

This is perhaps not surprising, given the cost of labour is the biggest input into services inflation. Domestic wage growth has not yet shown signs of abating.

The RBA has discussed one way of thinking about inflation as being the product of labour costs less productivity gains. The problem currently is that nominal unit labour costs have been accelerating while productivity has declined, which theoretically adds to the inflationary impulse.

Analysis of a broad range of economic indicators, that we assess below, makes it difficult to presently conclude that these objectives require lower interest rates in the absence of inflation being back in the target band.

Australia has experienced a rapid increase in interest rates. These higher interest rates have not been fully passed onto borrowers at this point, largely due to the continued gradual roll-off of fixed rate mortgages.

Despite this, bank loans in arrears remain relatively low compared to pre COVID-19.

The RBA estimates that at current interest rates approximately 5% of owner occupier borrowers have a cash flow shortfall. But over 65% of this cohort have built up sufficient savings buffers to cover their shortfalls for at least 6 months, as can be seen in the chart below, and according to the RBA in many instances for more than 24 months, which will allow them to weather higher rates for some time. Further, to the extent the mortgage stress forces a sale of the property, buoyant property market conditions reduce the risk to household equity.

The savings rate in Australia remains positive, albeit significantly lower than where it has been since the Global Financial Crisis (GFC).

Mortgage buffers remain quite significant, reflective of the fact that the savings built up during and shortly after COVID-19 remain largely intact, and significantly higher than they were in 2018, as can be seen below.

Unemployment in Australia is remarkably low at 3.7%. This is despite the participation rate being at near record levels, with 66.7% of the working age population in the workforce.

While job vacancies have declined recently, they are still significantly above where they were prior to COVID, suggesting ongoing labour shortages.

And these job vacancies persist despite population growth being at its highest levels in many decades, which supports economic growth, demand for goods and services and keeps the housing rental vacancies at very low levels. This has also no doubt contributed to house prices nationwide being at record highs.

Sharemarkets are also at record highs.

Leading to high levels of household wealth.

The distribution of effects from rising interest rates is uneven. The last Australian Bureau of Statistics household income and wealth survey indicated that 29.5% of households own their own home outright, as compared to 36.8% of households that have a mortgage.

Assuming that those who own their home outright on average have savings, from a cash flow perspective this large group benefit every time interest rates go up, because it leads to greater disposable income from cash earnt on deposit, while the group with a mortgage bear the stress of lower disposable income. This has led to different outcomes in consumption over the course of higher interest rates. As CBA highlighted recently, the spending growth rate of those in the 20-34 year old category has declined more significantly than those above 60 years old, the group more likely to have less mortgage debt and greater interest earning assets.

Unfortunately the RBA’s tools are blunt and cannot target particular groups. They are designed to work in aggregate, but the effects can be uneven and potentially unfair. It is up to the Government to ensure the effects are fair through redistribution measures available to them. To us it appears that the economy in aggregate is resilient. This leaves the question, if inflation remains above the top of the target band, is it a fait accompli that the RBA will reduce interest rates? Our conclusion is that it may be dangerous to make any investment premised on lower interest rates. While there are a range of possible outcomes, of which significantly lower interest rates is one, at this stage it does not appear to be particularly likely, let alone the most probable outcome.

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