Introduction

It is well accepted that the next move in interest rates in Australia (and across the other major global economies) will be up as the inflation backdrop and improvement in economic growth has put pressure on the central banks to tighten monetary policy.

The Australian economy has not had to deal with a hiking central bank for a long time. The last time that the RBA raised interest rates was more than a decade ago, in November 2010. This Econosights looks at the impacts of interest rate rises on Australian consumers.

The neutral interest rate

The neutral interest rate is a concept that is used to evaluate how accomodative or restrictive monetary policy is. The neutral rate is the cash rate that brings about full employment and stable inflation over the medium-term. If the cash rate (set by the central bank) is below the neutral rate then monetary policy is having an expansionary impact on the economy (working to increase economic growth through higher spending and lending). If the cash rate is above the neutral rate than monetary policy is having a contractionary impact on the economy (decreasing economic activity). It is important to be aware of where the neutral rate lies as the central banks take it into consideration when adjusting policy.

The RBA estimates that the neutral interest rate is around 2.5% 3.5% (in nominal terms). The cash rate currently sits at 0.1%, so it would take at least 250 basis points worth of rate hikes to get monetary policy back to “neutral” (rather than expansionary, like it is at the moment). This would take the variable rate back to its highest levels since early 2012 (see chart below)

However, the RBA is most unlikely to quickly hike interest rates to the “neutral level”. Because the neutral cash rate is not measured or directly observed, it could be higher or lower than expected. This means that the RBA needs to observe the impacts on the economy from initial rate changes. Changes in monetary policy also have a lagged impact on the economy (of around 12 months), so it will take time for the RBA to see impacts to the economy from initial rate changes before adjusting monetary policy again. This is why the RBA often moves in two increments of 0.25% and then waits to see the impact.

We expect the RBA to reduce its asset purchase program to $2bn/week from February (it is currently running at $4bn/week) before an eventual start to interest rate hikes in November 2022 (with the cash rate rising from 0.1% to 0.25%) and another 25 basis point hike in December, taking the cash rate to 0.50% by the end of 2022 and 1.00% in 2023. On current projections of economic growth and the unemployment rate, we think that the neutral interest rate would not be reached until 2025. This means that rate hikes up to that period will slow the pace of growth, but are unlikely to be enough to lead to an actual contraction in the economy.

The impact of higher interest rates on consumption

Fixed rate mortgages have already started to rise in Australia, (despite no changes to the cash rate) because global and Australian bond yields have risen from market expectations of higher interest rates , the conclusion of the the Reserve Bank of Australia’s Term Funding Facility to the banks (which was a form of cheap funding for the banks) and the abandonment of the 0.1% April 2024 yield target. The increase in fixed rates has been around 0.50% over the past two months. This only affects new home loans (which are worth around 50% of new lending) not existing ones. APRA has also recently increased the minimum interest rate buffer banks use when making new home loans by 0.5%. So, there has been already been a defacto tightening of interest rates over the past six months, without any increases to the cash rate. So far, this does not appear to have made a significant impact on household spending – although it may be masked by the impact of reopening in the east coast states.

Australia has one of the highest levels of household debt (as a share of income) in the developed world (see the chart below) with the total household debt to income ratio close to 184% in June. Most other major economies have experienced some level of household deleveraging since the GFC. But, Australian household debt is still around its record high and this makes Australian households more sensitive to interest rate changes.

Despite the continuing rise in Australian household debt, interest payments (as a share of income) have been declining over the past 20 years (see the chart below) because of the fall in the cash rate and hence mortgage rates.

Interest rate changes impact the servicability of housing debt. Households currently “spend” 4.7% of income on interest payments on housing debt, which is at its lowest level since 1998 and well below the historic average of 5.8%. This is why on some measures, housing affordability looks better than ever. But, this masks any principal payments made because this is considered a payment for an asset. If you account for housing principal payments, then the share of income going towards housing would have risen over time given that household debt is around a record high (which reflects record high home prices).

When housing interest payments grow too much (as a share of income), consumer spending growth slows down (see the arrows in the chart above). This becomes evident when interest payments reach 7-8% of income. On our calculations, it would take an increase in interest rates of at least 200 basis points from here, to get housing interest payments (as a share of income) to 7%. This would take the cash rate to around 2% or just below the level the RBA considers neutral.

The cash rate is unlikely to reach 2% until 2024. On our expectations, the cash rate will be at 1% in 2023 which will take interest payments to 5.8% of income, a lift from the current 4.7% at and around its long-run average level. While this lift in housing interest payments is likely to slow consumer spending, it should not be enough to cause a collapse in consumption. However, the risk is that households can only withstand fewer rate hikes because housing principal payments have increased as a share of income.

Household savings

Accumulated household savings provide some offset to rising housing interest repayments are rates go up. Households have increased their savings since the start of the pandemic and now have a large pool of excess savings that they can deploy, if required. On our estimates, the build-up in accumulated savings since the start of Covid-19 (driven by government fiscal payments) is worth around $160bn in Australia (see chart below) which is 8% of GDP. The savings pool makes us more confident about the near term outlook for consumers as interest rates start to rise.

Implications

The RBA does have room to move interest rates higher without derailing consumer spending and economic activity. However, the RBA will lift interest rates slowly. But, there will come a point when interest rate hikes tighten economic activity and lead to a slowdown in economic growth and lower inflation, especially as the cash rate moves towards its “neutral level”. We think that this point will be reached when interest rates are above 2% which is unlikely to happen until 2024. But, given that the economy has not experienced interest rate hikes for more than 10 years, it may also take fewer hikes to get a dampening impact to the economy.

Highter interest rates means that Australian nominal bond yields will move higher over the next few years. Equity market returns are also likely to be lower compared to recent years. However, a bear market is unlikely until earnings peak and economic activity slows.