This article is from the Australian Property Journal archive
OPINION: THE Reserve Bank of Australia is continuing to warn of further interest rate increases ahead as interest rates are returned to “more normal levelsâ€.
Introduction
The Reserve Bank of Australia has increased the cash rate five times from its low of 3%, taking it back to 4.25%. Moreover the consistent message from the RBA has been that more interest rate increases are likely. In simple terms, the RBA cut the official cash rate to generational lows of 3% early last year to help minimise the impact of the global financial crisis on the Australian economy. Yet, with the economy avoiding recession and growth now back around trend, it’s hard to justify interest rates below normal levels.
There is little doubt Australia’s economic growth has improved and the case for abnormally low interest rates has well and truly passed. While housing finance data and retail sales have recently been soft, indicators for job advertisements, employment, car sales, house prices, auction clearance rates, business investment and export earnings are all pointing to strong growth ahead. This is summarised in our leading growth indicator for Australia which is pointing to strong 5% growth ahead.
Source: Thomson Financial, AMP Capital Investors
However, while growth may be back at trend and probably heading above, the key questions are what is the “normal” level for interest rates and secondly, what is the risk we will go beyond this level some time in the next few years?
The normal or neutral interest rate
Most economists regard the normal or neutral rate of interest (above which monetary policy bears down on growth and below which it stimulates growth) as being roughly in line with the economy’s long term nominal growth rate. So with an inflation target of 2.5% and real potential growth thought to be around 3.25%, for a long time the neutral rate was thought to be around 5.75%.
However, last year there was increasing talk of a “new normal” rate, subsequently given credence by the RBA itself. This took its lead from the fact it is actual borrowing rates that businesses and households pay that matter. Due to increased bank funding costs, the banks’ borrowing rates were running at an above normal margin relative to the cash rate. For example, over the decade prior to 2008 the standard variable mortgage rate averaged around 1.8% above the official cash rate, whereas it is now about 2.9% above the cash rate.
Source: Thomson Financial, AMP Capital Investors
This would suggest that the normal cash rate has fallen by 1% or so taking it to around 4.75%. With the cash rate now at 4.25% this would suggest there is not a lot further to go up in terms of returning the cash rate to normal. Similarly, the average standard variable mortgage rate of 7.15% is now not that far below the average of 7.5% over the last decade and a half. All this would suggest interest rates are now pretty close to normal with only another 0.25% or 0.5% increase required.
The new, new normal interest rate
However, a counter view is starting to emerge suggesting the normal level for the cash rate is actually still around 5.5%. This view accepts that the spread between bank lending rates and the cash rate has widened but argues the potential real economic growth rate of the economy is actually around 4%. Over the last few decades Australia’s real growth rate averaged around 3.25% pa and it has been thought this represents the longer term potential growth rate of the economy reflecting labour force growth of around 1.7% pa and productivity growth of around 1.5% pa. However, several factors may be working to push Australia’s potential growth rate up towards 4% pa, viz:
A large increase in immigration levels is driving an acceleration in labour force growth. The increase in the working age population in Australia is now running at 2.2% pa, its highest level since the mid 1980s. Even allowing for some scaling back in immigration levels suggests labour force growth could be running around 2% pa over the next few years.
The super cycle in commodity prices is providing a big boost to national income and hence the economy that will likely continue for many years to come, short of some event terminating the industrialisation of China, India and other major emerging countries. For example the 90% increase in iron ore prices and the 50% increase in coking coal prices will provide a $35-40bn boost to national income (equal to 3% of GDP). In fact, the RBA has even cited this as a reason not to delay raising interest rates.
The boost to national income from the mining sector plus strong public sector infrastructure spending has pushed growth in the capital stock (ie, the stock of factories, machinery, commercial buildings and infrastructure) to its fastest pace in almost 40 years. This is likely to boost productivity growth.
If potential real economic growth has been boosted to 4% then allowing for 2.5% inflation this would suggest the normal cash rate (before allowance for wider spreads on bank rates) has increased from 5.75% to now 6.5%. Allowing for wider bank spreads brings the normal rate back to 5.5%.
The bottom line is that on this basis, the RBA still has quite a bit more work to do to return interest rates to normal levels. Rather than one or two more 0.25% rate hikes, this would suggest that there might be another five to go, just to get back to normal.
So how high will the cash rate go?
Yet regardless of what the normal level is, the experience in past cycles suggests at some point the cash rate will likely rise above normal. In the last tightening cycle the cash rate peaked at 7.25% in 2008. As in any cyclical upswing the reason this time around will be simple – if growth rises above the potential for a while (as our leading indicator on the first page suggests is possible) this would be seen as likely to push inflation above target levels.
On this basis, some are now suggesting the cash rate could well rise to its 2008 high of 7.25% some time in the next two years. However, there is good reason to believe this won’t be necessary as it would likely create significant problems for the Australian household sector. While the ratio of household debt to income has stabilised at around 155% over the last few years, it remains extremely high (well above that for other countries) and it has recently started to increase again. Similarly the proportion of household disposable income used for debt interest payments is starting to rapidly increase again (see the next chart). In fact the vulnerability of the household sector may have increased a bit lately as the aggregate debt figures likely mask faster repayments by older households with a mortgage but high average debt levels for the group of borrowers who recently entered the market on the back of the first home owners boost. This group is likely to be highly sensitive to rate hikes.
Source: RBA, AMP Capital Investors
The 2008 experience highlighted the vulnerability of the household sector – essentially when rates started to push above 9% real consumer spending slowed sharply in early 2008, quite clearly indicating that the RBA had gone too far. As a result the Australian economy had slowed to a virtual crawl in 2008 even before the global financial crisis hit in the December quarter that year. The pressure on households was only relieved when the RBA started slashing interest rates from October 2008.
A move back to a 7.25% cash rate would be far more negative for household cash flows this time around as it would imply – on current bank lending margins – a standard variable mortgage rate of 10.1% which is well above the 2008 peak and would take the proportion of interest payments to household income well above the 2008 high. Which is why it won’t be necessary and so most likely won’t occur. If the economy was already slowing significantly in 2008 when mortgage rates went above 9%, the same will likely happen this time around.
This all suggests the cash rate is more likely to peak around 6% or just above probably in 2012, rather than head on up to previous highs. This would imply that mortgage rates will likely peak at around 9%.
Concluding comments
While wider bank lending spreads have reduced the normal level for the official cash rate, possibly to 4.75%, strong immigration levels and structurally higher commodity prices are likely pushing it back up to around 5.5%. On this basis the RBA likely still has a bit more work to do to get the cash rate back to normal.
What’s more, it’s highly likely the cash rate will rise above this level in 2011-12. However, the heightened sensitivity of the household sector given high debt levels will likely see the cash rate top out at around 6% or just above in 2012.
We are allowing for another 0.25% cash rate hike in either May or June and the cash rate rising to 5% by year end, before moving up to a peak of around 6% or just above in 2012.
By Dr Shane Oliver, head of investment strategy and chief economist, AMP Capital Investors.*
Australian Property Journal
