Australia is pivoting on interest-rates because of fears about house prices

by Shaun Richards

This week is one that will be dominated by rises in interest-rates as domestically we await the Bank of England but also the whole world waits for the US Federal Reserve tomorrow. This morning we awoke to news from a land down under where according to Midnight Oil beds are burning.

At its meeting today, the Board decided to increase the cash rate target by 25 basis points to 2.85 per cent. It also increased the interest rate on Exchange Settlement balances by 25 basis points to 2.75 per cent.

That was from Phillip Lowe who is the Governor of the Reserve Bank of Australia. There are 3 immediate issues here. Firstly that the increase was only 0.25% when we have got used to a “new normal” of 0.75%. Secondly that there is a complete mismatch between the interest-rate and inflation as he kindly confirms below.

As is the case in most countries, inflation in Australia is too high. Over the year to September, the CPI inflation rate was 7.3 per cent, the highest it has been in more than three decades.

So they have slowed the rate of increase in spite of the fact that the rate of inflation is over 2 and half times higher than the interest-rate. As we also need to look forwards as interest-rates operate with a lag we in fact see that things are even worse.

A further increase in inflation is expected over the months ahead, with inflation now forecast to peak at around 8 per cent later this year.

There is an attempt to explain things with this.

Inflation is then expected to decline next year due to the ongoing resolution of global supply-side problems, recent declines in some commodity prices and slower growth in demand. Medium-term inflation expectations remain well anchored, and it is important that this remains the case. The Bank’s central forecast is for CPI inflation to be around 4¾ per cent over 2023 and a little above 3 per cent over 2024.

So they are suggesting that inflation will be lower next year and thus they do not need to increase interest-rates by much more.  Let us look back to last year to see how good they are at looking ahead as here is the statement from the 2nd of November 2021.

The central forecast is for underlying inflation of around 2¼ per cent over 2021 and 2022 and 2½ per cent over 2023.

As you can see they were completely wrong about this year by a factor approaching four and as we stand now think inflation next year would be double what they thought then. In fact they were so sure of this they kept interest-rates at record lows.

The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range….. The Board is prepared to be patient, with the central forecast being for underlying inflation to be no higher than 2½ per cent at the end of 2023 and for only a gradual increase in wages growth.

It was a clear policy error and one of the biggest of our times but for our purposes today we can see that their claimed rationale for reducing the pace of interest-rate rises is based on wishful thinking. More specifically based on economic models which could not have been much more wrong.

The third issue is how do you end up with an interest-rate of 2.85%?

Contradiction Time

The economy is awkward for them as we note an indicator that we have been guided to in the past.

The labour market remains very tight, with many firms having difficulty hiring workers. The unemployment rate was steady at 3.5 per cent in September, around the lowest rate in almost 50 years. Job vacancies and job ads are both at very high levels….

So we are around the lowest unemployment rate for 50 years and the growth pattern is much better than elsewhere.

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The Bank’s central forecast for GDP growth has been revised down a little, with growth of around 3 per cent expected this year and 1½ per cent in 2023 and 2024.

Commodity prices have fallen in some areas but Australia must be benefiting from the LNG and coal boom.

Over the past year, the index has increased by 22.4 per cent in SDR terms, led by higher LNG, coking coal and thermal coal prices. The index has increased by 28.9 per cent in Australian dollar terms. ( RBA)

After he enjoyed his dinner in Hobart Governor Lowe confirmed this.

Our economy has bounced back better than most from the COVID-19 disruptions and we are benefiting from a surge in the prices of our key exports.

There is an obvious problem here as apparently Australia needs to increase interest-rates by less because it is doing better!

House Prices

If we now switch to what usually determines RBA policy we see that they were on their minds. From the official statement.

Another is how household spending in Australia responds to the tighter financial conditions. The Board recognises that monetary policy operates with a lag and that the full effect of the increase in interest rates is yet to be felt in mortgage payments. Higher interest rates and higher inflation are putting pressure on the budgets of many households. Consumer confidence has also fallen and housing prices have been declining following the earlier large increases.

So they are worried about the rise in mortgage interest-rates and hence mortgage costs and the implication for house prices. Perhaps suitably refreshed Governor Lowe went further at the dinner.

I understand that the higher interest rates that are needed to bring inflation under control are unwelcome by many people, especially those who have borrowed large amounts over recent times.

Who was that person who encouraged Australians to borrow so much? Here is Governor Lowe from a year ago.

Financial conditions in Australia remain highly accommodative, with most lending rates at record lows.

Comment

The basic point is that one of the stronger world economies is in the midst of what has become called the “pivot” on interest-rates. Indeed if we note these bits from the dinner speech there may be more to come.

This morning, we also discussed the consequences of not raising interest rates,

And….

Similarly, if the situation requires us to hold steady for a while, we will do that.

Our intrepid inflation fighters seem to be getting cold feet. If you follow my work you will know that my theme is that so much of central banking policy is driven by house prices. Looking at the figures below confirms that as we see how enormous rises were ignored but what are still small falls are getting an instant policy change.

House prices across the nation have continued to fall despite the spring selling season getting underway.

Prices have fallen by 0.06 per cent nationally, with a 0.11 per cent drop in Australia‘s capital cities according to PropTrack’s Home Price Index, the smallest fall since the March peak.

Hobart and Canberra led the declines with 0.46 per cent and 0.37 per cent dips respectively, followed by Sydney at 0.21 per cent.

But the dip isn’t a reason to panic according to property experts, with prices still up 30.2 per cent when compared with pre-pandemic levels. ( news.com.au )

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