An Alternative Scenario for Domestic Interest Rates

With large amounts of stimulus being injected into the US economy by its government, there appears to be mounting inflationary pressures.  It is clearly a possibility any rise in US domestic inflation is exported globally to Australia.  Independently, our own government and the RBA continue to stimulate the Australian economy, with economic data released over the last few months having been exceptionally strong.  Record highs have been set for consumer and business confidence, business conditions and house prices.  The latest GDP figures were higher than expected due to increased business investment and the unemployment and under-employment rates are falling rapidly. 

In summary, the RBA’s clearly laid out plan to drive unemployment below the NAIRU (Non-Accelerating Inflation Rate of Unemployment) such that inflation does start to accelerate appears well on track if not ahead of schedule as the RBA keeps revising down its forecasts for unemployment with each quarterly statement of monetary policy it releases.

Market and mainstream expectations are when higher consumer price inflation emerges the RBA will raise interest rates to keep inflation within the 2% to 3% target zone as this is its mandate.  For example, CBA recently forecast interest rate rises starting in November 2022 based on the RBA being “forced” into them because of higher wage inflation hitting the RBA’s target earlier than expected.  However, there is an alternate scenario which is the RBA simply tolerates a higher level of inflation than expected without raising interest rates. 

To do so would still be consistent with its mandate to maintain inflation within the 2% to 3% band across the cycle as with years of tolerating inflation below the target band, it can presumably tolerate years of inflation above the target band to bring the long run average back within the band!  Letting inflation rise is also consistent with the RBA’s statements which it continues to defend staunchly that it does not expect to raise interest rates until “at least 2024” and also its implicit commitment to keep the April 2024 government bond at a yield of 0.10% until it matures.

Why would the RBA do this and why could it be good policy? 

Firstly, the level of debt in the Australian economy is at unprecedented levels, particularly household debt and while debt service ratios for mortgagees are high they are currently manageable only because interest rates are so low.  If average variable mortgages rates are around 2.50%[1] with the cash rate at 0.10%, presumably with a cash rate of 2.50% mortgage interest payments would be close to 5.00% which would double interest payments for those on interest only loans and close to double payments for those on principal and interest loans early in their term.

While it is questionable the effect a doubling of mortgage payments would have on default rates from those unable to meet the payments (and presumably a sharp rise in rents for those who do not own their own homes as rents are tied to mortgage rates and investors would want to cover their mortgage payments) dependent on the buffers they have in place, there is far greater consensus within the view that such a rate rise would have a massive dampening effect on consumer demand as monies spent on other things would now be devoted to meeting increased mortgage payments. 

As the judge said in determining whether Westpac’s mortgage lending practices were sufficiently responsible in a case brought against them by ASIC in 2015, “I may eat Wagyu beef everyday washed down with the finest shiraz but, if I really want [to keep] my new home, I can make do on much more modest fare” in regards to the sacrifices homeowners could make to meet their mortgage repayments, but of course such sacrifices will dampen the market for wagyu and shiraz (but possibly boost goon and dogfood sales).

There is a strong argument high inflation and “higher” interest rates (as defined as more than 1% higher than current interest rates) cannot co-exist because the “higher” interest rates would be suppressing the excess demand that was causing higher inflation.  Historically, “doubling” interest rates has been the tried, tested and true method of squashing inflationary pressures across the world since the early 1980s.

A secondary question also arises which is how the current level of debt can ever be repaid?  If the logic above is accepted, then interest rates cannot “normalise” to rates of 5%[2] until the current levels of debt fall substantially so the RBA has lost this policy tool.

Historically, debt was repaid in the long-term as its real value was eroded by higher wage increases so that mortgage stress, when it existed, only generally lasted for the first few years of a home loan.  Higher nominal wages were driven by two factors being inflation and productivity increases so the escape route other than default was a combination of “growth” and inflation.  Worker productivity gains have fallen substantially in the last decade which is one of the reasons wage growth is currently so low so “growing” out of the problem does not seem to be a practical option.

Inflation cannot be the “debt escape route” for either individual mortgage holders or businesses at current levels and unless the levels of debt in the economy are reduced the economy remains perpetually vulnerable to higher interest rates whose effects cannot be tolerated in a Catch 22 situation.

A potential “solution” to both the short and long-term problems is to maintain interest rates close to current levels and tolerate “historically moderate” inflation of close to 5% which would have the effect of boosting wages (assuming wage inflation at least matches CPI) easing immediate mortgage payments and progressively eroding the real value of the debt outstanding each year (the “real” value of the debt erodes at the inflation rate which would be 5% not 1% as it is currently).  Home lending could be controlled by macro-prudential regulation to stop the outstanding mortgage debt rising and perhaps create an ideal situation where house prices were rising in nominal terms but falling in real terms, making them progressively more affordable without cruelling existing homeowners (something any government wanting to get re-elected would seek to avoid).

If this scenario is considered as viable and pursued by the policy makers, then clearly as per their statements, the RBA will not be putting up interest rates until 2024 or beyond as to get wage growth and inflation close to 5% will not occur in the short-term.

[1] RBA figures for new loans at the end of April sourced from the RBA website

[2] The average cash rate over the 20 year period to 2012.  Previously the cash rate was much higher

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