The RBA has increased the cash rate to 2.35%, the highest level since early 2015.
We’ve had five successive increases, the fastest in three decades. With the media frenzy and Australia’s leading economists releasing alarming reports, we must consider whether the RBA is overstepping the mark or tracking the right course.
CBA has warned us of an 18% drop in property values. This is a vision of rising economic carnage rates could have on Australian mortgage-holders without government intervention. The stakes are set high – property is a crucial capstone of the Australian economy. Our property market is worth $10.2 trillion and underpins a multi-trillion-dollar financial services sector. CBA is flagging that rates pushed too high too quickly would stretch the property bubble to its limits. With 957% of Australian households’ wealth stored in property and debt to income ratios at 187%, even a minor slide in property values would create an avalanche of pain for people’s cash flows.
A weak property market is not just a horseman of economic crisis; it is the primary cause. Japan’s stagnant 1990s and the Global Financial Crisis stand as ominous reminders of the damage a burst asset bubble can cause to the domestic and world economies. Yet CBA’s prediction is not a foregone conclusion – it is one possible future of many. If the cash rate goes beyond the CBA’s proposed hypothetical maximum of 2.6%, the future they are predicting might become a reality.
Often it is difficult to gauge the effect of interest rate changes in the short term. According to the Commonwealth Bank’s head of Australian economics Gareth Aird, there is a significant delay in the cash flow effect of a rate rise. He argues that most Australian households are just feeling the sting of the first two rate rises, let alone the more recent ones.
This is because interest accrues after the bank’s effective rate changes, which tends to be two weeks after the RBA’s rate announcement. It is only following this recast of monthly repayments and a 32-day notice period that borrowers pay a higher minimum payment. There is a lag of about two to three months for the larger lenders. Cumulatively the effect is enormous. These consecutive rises would lift the monthly repayments on an $800,000 mortgage by $1000 since May.
The RBA is aware of this. Yet they feel that the Australian economy is caught in a crosswind. On the one hand, high inflation, rising interest rates, falling house prices, and falling consumer confidence should be curtailing. On the other hand, people working more hours, earning higher wages, maintaining large financial buffers, and increasing their savings rate are boosting their ability to spend. What we end up with is a neutralising effect, where some of the visible fronts of the economy become noticeably slower, but essential drivers of inflation are not yet cooling.
One key driver is consumption, which has increased 18.4% throughout the year, according to the ABS. Economic theory suggests that as consumption declines and the economy slows, prices will fall as suppliers lower prices to clear their inventories and entice consumers back in. This addresses the RBA’s primary concern of high inflation or ‘an increasing price level.’ Lifting the cash rate is the RBA’s flagship strategy. As rates rise, people have less disposable income for consumption and will reduce the amount they spend, bringing their behaviour in line with that required by a slowing economy.
Yet economic theory seems misaligned with the current reality. Retail sales hit an all-time high of $34.7 billion in July, up 1.3% from the month before and up 16.5% from this time last year. Demand is unusually strong, particularly given the high rates environment we find ourselves in. People are not curbing their spending, and firms have no incentive to lower prices. We are not seeing signs of a ‘slowing economy’ to what the RBA wants. There are a few divergent explanations for this. Households may be anticipating higher prices in the future and are making their purchases now to factor this in. Such expectations would be highly justified, given the RBA’s statement that inflation will reach near 8% in 2022.
Then again, people may be willing to dip into their savings buffers accumulated throughout the pandemic to keep on top of mortgage repayments and maintain an elevated level of consumption. The increased spending may also be due to wage increases. Many corporates offer higher salaries to workers to help preserve real wages, while the national minimum wage increased by $40 per week from July 1 2022. From this, we can conclude that demand is not falling with rising rates.
Mr Aird cautions, “there is a clear risk that the RBA continues to tighten policy aggressively because it appears that demand in the economy is not slowing sufficiently to put the desired downward pressure on inflation.” He is absolutely correct, the RBA is running ahead with its hawkish policy direction because people’s spending habits are not reacting to policy in conventional ways. Yet these demand side effects are not the only driver of inflation we should be worried about.
A report penned by the Australia Institute reveals that the increase in prices has been faster than wage growth and increases in other costs of production by a disproportionate margin. Many corporate spokespeople, like Gerry Harvey, argue that they have ‘no choice’ but to raise prices when costs rise. This is categorically false. Increasing prices consistent with or above changes to the costs of inputs is a choice to put profits over the community. It is not in the spirit of a fair Australia or a fair consumer landscape. This explains much of the inflation in Australia, which has been due to a widening of corporate profit margins rather than an increase in commodities or operating costs as businesses would have you believe.
The data from the Australia Institute above paints a telling picture. From 2013 to 2021, unit labour costs played virtually no role in price increases. Amidst the current inflation surge, only 15% of the increase in GDP deflator (aka aggregate price level) was due to input and labour, whilst 60% came from increased profits. This disparity is not trivial. It is responsible for businesses recording record profits while consumers battle a cost of living crunch. Furthermore, businesses have been able to justify this with rising energy prices and wages, which have been prevalent in the media. The graph above reveals the gross error in this lie.
This is where the RBA missteps. Increasing the cash rate will do nothing to curb inflation caused by bloated business profit margins. This may explain an element of CBA’s dire warnings. Without a change to government policy offsetting some missteps of the RBA’s monetary policy, there could be a collapse in the property asset bubble with damaging consequences.
This raises the question, what would be the best case scenario for CBA, given its huge stake in this situation?
Firstly, CBA hopes to slow and eventually halt increases in the cash rate of the RBA. Its prediction of an 18% property slump is a worst-case scenario that may eventuate without intervention in the market. In its messaging, CBA hopes to motivate Australian households to incite public backlash in favour of government action.
The government has many options. It could introduce better competition policies to control price increases by profit-hungry businesses, release financial incentive packages to take the strain off first-home buyers and investors, or approve more small business grants to stimulate economic activity. The proposal of the NSW government to switch stamp duty for land tax will also support property values, as buyers will only need to save for a deposit and not the exorbitant extra cost of stamp duty – opening up a higher price ceiling. Furthermore, state governments could increase support for business tenants, allowing landlords to raise costs to meet the demands of more expensive lending facilities, thus maintaining commercial property values.
Competition policies would have a powerful effect on limiting the rate of inflation. Rising profits are the primary driver of inflation from the graph above, not the cost of inputs, wages or excessive demand. Government policy, not an increase in the cash rate, is needed to address this issue.
We can only hope that CBA’s warning does not become a reality.