Rates rise again: Are we there yet?

Reserve Bank Board meeting

  • The Reserve Bank has increased the cash rate for the third straight month, lifting rates by 25 basis points (quarter of a percent) to 4.50 per cent. But the good news for borrowers is that the Reserve Bank has signalled that interest rates have returned to “normal”, that is “rates for most borrowers will be around average levels” as a result of today’s decision.
  • The Reserve Bank may have signalled “neutral” or “normal” monetary policy settings but it retains a tightening bias, noting that inflation may not decline as much as earlier thought.

What does it all mean?

  • Interest rate settings are back to “normal” – that is, rates are at levels that are not serving to speed the economy up or slow it down. So stage one has been completed, now for stage two. The $64 million dollar question is whether the Reserve Bank now feels comfortable with current rate settings and will give the higher rate settings a chance to work their magic on the economy.

  • There is no question that the rate hikes are starting to hurt. Two listed retailers have delivered profit warnings in the past two days and both Woolworths and Wesfarmers have recently highlighted that consumer spending has tightened. Small business – especially retailers, manufacturers and tourist operators – is particularly at risk in this environment. Small businesses are already paying above-normal borrowing rates – just over one percentage point more than longer-term averages. A small business owner with a $500,000 loan now has to find an extra $512 to meet monthly loan repayments compared with a year ago.
  •  If the Federal Government wants borrowers to be spared further pain it will need to make the hard decisions in next week’s budget. Reserve Bank policymakers have to be assured that fiscal policy is doing some of the heavy lifting work before it will be content to move to the monetary policy sidelines.
  • The $64 million dollar question for most people is how high rates will go. But there is an even more fundamental question – what is the indicator that will tell the Reserve Bank that now is the time to stop lifting rates?

  •  As always the response to today’s rate hike will vary. A third of Australia’s households won’t be unduly concerned, having paid off the home mortgage. In fact if they have savings they may rejoice in the decision. Another third of households will have mixed feelings – that is, those who are renting. But for mortgagees, the rate hike will mean more bad news and more budgeting. Someone with a $300,000 home loan is paying $310 a month more in repayments than they were a year ago. That’s got to hurt.

Interest rate decision and past cycles

  • The Reserve Bank Board has increased the cash rate by 25 basis points to 4.50 per cent. In October 2009 cash rates stood at a 49-year low of 3.00 per cent. But then the RBA embarked on a process to remove the emergency stimulus, lifting the cash rate by a quarter of a percent in October, November and December 2009, March and April 2010 with the latest rate hike today. Six rate hikes in seven meetings.

  • In the last rate cutting cycle the cash rate fell to lows of 4.25 percent in December 2001. In the two previous rate cutting cycles, the cash rate fell to lows of 4.75 per cent. 

  • If major banks pass on the rate hike in full, the average bank variable housing rate would lift to 7.40 per cent, above the long-term average of 7.15 per cent. So mortgage rates are back to ‘normal’.

  • The Reserve Bank says that both underlying and headline inflation are now around 3 per cent. But the Bank says “Nonetheless, the extent of decline from here may not be quite as much as earlier forecast and inflation now appears likely to be in the upper half of the target zone over the coming year”

What are the implications of today’s decision?

  • Until now consumers have remained confident, but the rate hikes have made them reluctant to spend. But now those confidence levels are under threat and that means more budgeting and even less spending. Not only are interest rates marching higher but petrol prices, utility charges and health costs are all moving higher. Retailers are already hurting and they are poised for further pain over the next few months.

  • So where do rates go from here? There is now a far stronger case for the Reserve Bank to pause in the rate hiking cycle – especially given the fact that it now believes borrowing rates are back to ‘normal’. But more than likely the Reserve Bank won’t be able to stop at 4.50 per cent – even though those rates are the highest in the developed world. The Reserve Bank will need to move monetary policy to restrictive settings – designed to slow the economy down – over the second half of 2010. Borrowers should work on the assumption of cash rates between 4.75-5.25 per cent at end year.

MEDIA RELEASE

STATEMENT BY GLENN STEVENS, GOVERNOR
MONETARY POLICY

At its meeting today, the Board decided to raise the cash rate by 25 basis points to 4.5 per cent, effective 5 May 2010.

Recently, forecasts for world GDP growth have been revised up again, and growth is expected to be at trend pace or a little above in 2010. Conditions in Europe remain quite weak, though recent data suggest growth is becoming more established in North America. In Asia, where financial sectors are not impaired, growth has continued to be strong, contributing to pressure on prices for raw materials. The authorities in several countries outside the major industrial economies have now started to reduce the degree of stimulus to their economies. 

Global financial markets are functioning much better than they were a year ago, but sovereign risk concerns have escalated significantly in Europe over recent weeks. This has prompted additional efforts by policymakers to put fiscal policies onto a sounder footing and to provide support for Greece in the near term. To date, there has been very little contagion outside Europe. 

Australia’s terms of trade are rising by more than earlier expected, and this year will probably regain the peak seen in 2008. This will add to incomes and foster a build-up in investment in the resources sector. Under these conditions, output growth over the year ahead is likely to exceed that seen last year, even though the effects of earlier expansionary policy measures will be diminishing. The process of business sector deleveraging is moderating, with business credit stabilising and indications that lenders are starting to become more willing to lend to some borrowers, though credit conditions for some sectors remain difficult. Credit outstanding for housing has been expanding at a solid pace. New loan approvals for housing have moderated over recent months as interest rates have risen and the impact of large grants to first-home buyers has tailed off. Nonetheless, at this point the market for established dwellings is still characterised by considerable buoyancy, with prices continuing to increase over recent months.

Recent data on inflation confirm that it has declined from its peak in 2008, helped by a noticeable slowing in private-sector labour costs during 2009, the rise in the exchange rate and the earlier period of slower growth in demand. In both underlying and CPI terms, inflation over the most recent 12 months was around 3 per cent. Nonetheless, the extent of decline from here may not be quite as much as earlier forecast and inflation now appears likely to be in the upper half of the target zone over the coming year. 

With the risk of serious economic contraction in Australia having passed some time ago, the Board has been adjusting the cash rate towards levels that would be consistent with interest rates to borrowers being close to the average experience over the past decade or more. The Board expects that, as a result of today’s decision, rates for most borrowers will be around average levels. This represents a significant adjustment from the very expansionary settings reached a year ago. 

The Board will continue to assess prospects for demand and inflation, and set monetary policy as needed to achieve an average inflation rate of 2–3 per cent over time.

Source Craig James, Chief Economist, CommSec.