On the rack

As the Reserve Bank starts the inexorable process of ratcheting up interest rates to cope with rising inflation, the question is how high, writes AICD chief economist Mark Thirlwell MAICD.

The Reserve Bank decision to start “normalising” the level of the cash rate at its meeting on 3 May saw Australia’s first policy rate increase since a 25 basis points (bp) hike in November 2010, ending a sequence of 15 consecutive meetings when rates were unchanged. The cash rate target was increased by 25bp to 0.35 per cent. Financial markets had been predicting a 15bp rise, so while the increase itself wasn’t a shock, its magnitude was a surprise, seemingly indicating a newfound urgency on the part of the central bank.

It also marked the unwinding of the second phase of the monetary policy experiment described in a previous column — the strategy of being patient with inflation and keeping the cash rate lower for longer in order to attain the glittering prize of a sub-four per cent unemployment rate — at the risk of either future policy rates having to be higher, a steeper adjustment path, or both. In the event, the RBA decided to hike before the actual unemployment rate had a three in front of it, although it did say that its new central forecast was for the unemployment rate to “decline to around 3.5 per cent by early 2023 and remain around this level thereafter”, reminding us that this “would be the lowest rate of unemployment in almost 50 years”. If that proves correct, Martin Place will still be able to declare victory on its labour market objective. Meanwhile, the RBA has had to significantly revise up its views on inflation and the likely trajectory of interest rates.

Remember, through much of 2021 up to and including October’s monetary policy meeting, the RBA’s forward guidance had been that any rate increase would not occur until actual inflation was sustainably within the RBA’s 2–3 per cent target range, and that “the central scenario... is that this condition will not be met before 2024”. As recently as February this year, while conceding that a cash rate increase in 2022 was now a “plausible” scenario, the RBA was still saying that it was also plausible that any rise could be a year or more away. Likewise, it was at pains to stress a degree of policy forbearance with regard to price pressures, reiterating after the March 2022 monetary policy meeting that it was prepared to be “patient” with inflation.

RBA change of heart

Evidence of a rethink at Martin Place arrived with the 5 April meeting, when although the RBA left the target cash rate unchanged at 10bp, any mention of patience with regard to the inflation outlook was abruptly banished from the policy statement.

Then, on 27 April, the release of the March quarter 2022 Consumer Price Index (CPI) confirmed that the rate of increase of prices was running well-ahead of expectations. The Q1 numbers had been expected to be hot — the median forecast was for a headline annual inflation rate of 4.6 per cent and an underlying inflation rate (as measured by the trimmed mean) of 3.4 per cent. However, actual headline inflation surged to 5.1 per cent while underlying inflation jumped to 3.7 per cent. The former was the highest rate since the June quarter of 2001, following the introduction of the GST while the latter was the highest since 2009, marking the first time the trimmed mean had been above the top of the 2–3 per cent band since the opening quarter of 2010.

Higher fuel, housing and food prices drove a large share of the quarterly rise, but signs of inflationary pressures were broader-based, with 10 of the 11 groups that comprise the CPI increasing. Although much of the acceleration in inflation reflected international factors — including disrupted commodity markets and stressed global supply chains — there were also signs of growing domestic capacity constraints and rising wage pressures.

As a result, the RBA has substantially revised its inflation forecasts. It now expects headline inflation this year of around six per cent and underlying inflation of around 4.75 per cent, with both rates only moderating to around three per cent by mid-2024. Previously, it had been predicting underlying inflation to the end of 2022 at just 2.75 per cent.

Belt-tightening beckons

How high will the cash rate have to go to tame inflation? While RBA Governor Philip Lowe has stressed that rates are “not on a preset path”, he also noted that those new inflation forecasts are consistent with an increase in the cash rate to 1.5–1.75 per cent by the end of this year, and to 2.5 per cent by the end of next year. That would imply at least 215bp of tightening still to come by the end of 2023 — a total of 240bp of rate hikes.

Relative to recent tightening cycles — until now, there have been three in the current century — that would be significant. For example, the first of those cycles (which actually started in late 1999) saw the cash rate target increased by 150bp between November 1999 and August 2020. The second saw rates go up by more, but over a more extended period, with 300bp of increases between May 2002 and March 2008 during the long commodity boom. And the third saw 175bp of increases between October 2009 and November 2010.

At the same time, it’s important to note that the starting point for the current cycle was an historically low cash rate and that a normalisation process with a final or termination rate of 2.5 per cent would similarly be low by the standards of those previous cycles, where the termination rates were 6.25, 7.25 and 4.75 per cent, respectively.

Importantly, the current household debt burden is much higher than during those previous cycles, implying a greater sensitivity to interest rates and a lower “neutral” rate. As of Q4:2021, the ratio of household debt to income stood at a little over 186 per cent. That compares to ratios of around 109 per cent at the start of the first tightening cycle described above, 124 per cent at the start of the second, and 162 per cent at the start of the third.

Of course, those interest rate assumptions may well be wrong. As we’ve just been reminded by significant revisions to the RBA’s inflation forecasts and the likely trajectory of the cash rate, prediction is hard. For example, at the time of writing, market expectations were considerably more aggressive, with futures implying a cash rate closer to three per cent by the end of this year. That would suggest a far greater strain on the economy in general — and on indebted households in particular — relative to the more gradual rate path underpinning RBA projections.