This week, the Reserve Bank increased interest rates by 0.25%. This comes in response to last week’s ABS figures that showed first quarter inflation was above 5% annualised, while underlying inflation was 3.7% — well above the RBA’s target band of 2% to 3%.
This is the first time the RBA has raised interest rates in more than 10 years. Of course it’s also the first time inflation has been above the target band since 2010. In fact, it has spent most of the past six years at, or below, the bottom of the target.
As the RBA chose to act during the election campaign, it is unsurprising this has fed into the pre-existing political stoush over cost of living pressures. On social media, some have argued this represents a politicisation of the RBA.
It’s worth unpicking this to understand where the real problems lie.
First, the simple fact is that any decision by the RBA during the election campaign would be viewed through a political lens.
Once inflation had broken through the top of the band — especially when coupled with expectations that it would continue to rise in the near term — inaction by the RBA would be every bit as political an act as raising rates.
The RBA is also obviously aware of the potential political impact of its decision because it is at pains to stress that they are merely “withdrawing some of the extraordinary monetary support” and that the economy is functioning better than expected.
Nor is it the first time they have raised rates during a campaign, having done so in 2007.
Of course, it is fair to criticise the RBA for repudiating its previous guidance — especially with regard to the need for higher wages growth, for which little evidence currently exists. However, the consensus from economists seems to be that the unexpectedly high inflation figure required some action by the RBA.
Of greater worry is what will happen if inflation doesn’t “start moderating as some of the supply disruptions are resolved and/or as prices settle at a higher level” as the RBA expects. The RBA is already expecting future interest rate increases, but the market appears to be expecting even more.
Financial markets are pricing in interest rate increases of more than 2% this year, and further large increases in 2023. Two year fixed mortgages are already at or above 4% in several major financial institutions, compared to variable rates that are still near 2%.
This would be a far bigger concern from a cost of living perspective than this week’s increase in rates.
After all, without wanting to unfairly downplay the effect of any increase in mortgage repayments — given the enormous level of household debt — even after the increase, interest rates remain at the incredibly low level of 0.35%.
Almost all homeowners should have enough of a buffer to cover increases of 25 basis points like this week’s announcements. No-one could reasonably expect interest rates to stay at emergency levels forever.
But eight or more similar increases in a 12 to 18 month period would begin to seriously stretch many household budgets. An increase of that size undertaken so quickly would be quite unusual, historically. It is hard to see how either major party could ignore such a rapid increase, or that it would not cause significant collateral damage to the economy.
With average loan sizes for owner-occupiers in the ACT exceeding $625,000, for example, this week’s increase is about an extra $80 a month. However a 2% increase would add almost $700 to monthly repayments.
However, it would still be a mistake to consider this in isolation.
Historically, inflation has actually been a good thing for those with big mortgages — despite the associated interest rate increases — provided that wages are keeping pace with inflation.
The reason is fairly simple: the size of your loan doesn’t adjust for inflation, so your repayments are fixed while your income increases, and this effect compounds over time.
For a family income of $100,000, inflation and wage increases at 4% annual would result in a family income of almost $150,000 in 10 years time. Meanwhile, absent interest rate rises, loan repayments would remain unchanged. At the start, on an average loan balance, repayments would be around 30% of gross income, but by the end they would be less than 20%.
Even factoring in a 2% rise in interest rates, it would be less than 25% of gross income in year 10.
The RBA remains aware of the importance of wage increases to future inflation expectations. Indeed, though many commentators are using market expectations of future rate rises to predict doom for homeowners, it is shifts in labour costs that would drive persistently high levels of inflation.
As has been the case in previous inflationary episodes in Australia — even those started by external price shocks — it is the wage-price spiral you really have to worry about.
In those circumstances, it is not homeowners with big mortgages who would be most at risk, but those on fixed incomes and retirees living off savings.
In the end then, though unexpectedly high inflation and interest rate rises were big issues for the campaign, it’s likely the ABS release of wages data next Wednesday will be the most important economic data point.
The return of strong wages growth reflecting the tightening labour market would be good news for the government in more ways than one. Evidence that wages and inflation were on divergent paths would be a very tough blow to recover from just four days out from polling day.