The rate hikes we had to have

‘Cautious’ mightn’t be the word mortgage holders would use to describe a central bank that just lifted interest rates by an unprecedented 300 basis points in seven months. And yet by global comparison, it is an apt description of the RBA’s policy stance to date. While other central banks have embarked on a once-in-a-generation synchronised tightening of monetary policy, the RBA has remained reluctant to go on a virtuous crusade against inflation and risk inflicting even more pain on indebted households. The recent inflation data suggest that such caution may present its own set of risks. Nobel laureate Paul Krugman’s 2008 assertion with regard to policymaking in unusual economic times seems to appropriately describe the RBA’s 2023 challenges: ‘virtue becomes vice, caution is risky and prudence is folly’.

For over a decade following the global financial crisis, advanced economies appeared stuck with stubbornly low inflation and lacklustre economic growth. Then in late 2021, initially spurred by supply chain challenges and exacerbated by Russia’s invasion of Ukraine, the aftermath of the pandemic left the global central banking fraternity grappling with the opposite problem. Prices spiked the most since inflation targeting was adopted in the early 1990s. Accommodative fiscal policy, appropriate through the pandemic, added fuel to the fire. What most economists and central bankers believed to be transitory inflation appeared more enduring. As the denial gave way, flustered central banks sought to curb inflation the only way they know how – using the blunt instrument of demand management.

To date, the US Federal Reserve (Fed) has led the charge, lifting rates by 425 basis points. The RBNZ appear on track to exceed a 5 per cent cash rate. Even the perennially dovish ECB and Bank of Japan have been unusually hawkish. While it may not seem this way to mortgage holders, the RBA has remained relatively cautious, with some suggesting (before the latest CPI print) that policy rates may not increase at all in 2023.

Why is this so? History suggests that rapid policy tightening often risks recession and higher unemployment. In Australia, that risk is magnified by the highly indebted household sector. The RBA has one of the more potent means of impacting household behaviours due to the relatively high proportion of loans that are either floating or soon will be. In the US, by contrast, mortgage rates are typically fixed for 30 years. And while Australians recently piled into fixed rate loans, they did so typically for less than three years. Two thirds of these mortgages will reset at much higher rates over the next 12 months – the so called ‘mortgage cliff’. As a result, policy settings will continue to tighten even if the RBA stops raising rates tomorrow. The potential impact on households, who are experiencing reversals in real income, wealth and confidence, is a key downside risk to the Australian economy in 2023.

Another reason for the RBA’s caution is the additional impact of the unwinding of the Term Funding Facility (TFF) used to provide banks with close to free three-year loans during the pandemic. This TFF funding matures between mid-2023 and mid-2024, forcing banks to seek more expensive financing elsewhere. This may lead to pressure for banks to put through out-of-cycle mortgage rate increases. The RBA must calibrate its own policy setting to cater for this possibility.

In June last year, RBA Governor Lowe described a ‘narrow path’ in which inflation could come down without too much economic pain. After last week’s Q4 inflation data, this narrow path appears more like a tight rope. The all-important trimmed mean measure of CPI was above the RBA’s expected peak in the December quarter, increasing the probability of further interest rate increases. So while US inflation may have peaked, giving central banks hope that the dragon can be defeated, the Australian context remains uncertain. Rising rents, utility bills and food prices may prove far ‘stickier’ due to pressures unique to this country. The RBA’s caution to date, as Krugman warned, may indeed have become risky.

If the RBA remains hesitant to match the tightening pace of other central banks, employment will benefit, particularly in an environment of expanding labour supply. However, this risks inflation remaining elevated for an extended period. On the contrary, if the upside inflation surprise elicits more aggressive tightening by the RBA, then a more pronounced slowdown in the economy, triggered by mortgagee pain, appears inevitable.

For what it’s worth, we still believe that caution is inherent in the RBA’s DNA. Nonetheless it seemingly has little alternative but to raise rates in February at a minimum and possibly in March. But it will do so with a dovish bias reflecting its caution signalling a potential pause thereafter. This path could leave inflation above target for some time, and also interest rates elevated for an extended period. In this way, the RBA could be among the first major central banks to stop hiking but the last to start easing.