RBA warns of more interest rate pain to come

The Reserve Bank has signalled a need for sharply higher interest rates to stay on top of inflation expectations.

RBA Deputy Governor Michele Bullock. Picture: John Feder/The Australian.

The Reserve Bank has signalled a need for sharply higher interest rates to rein in demand and stay on top of inflation expectations after a period of exceptionally low rates during the pandemic.

Minutes from the RBA’s July board meeting, at which the Bank decided to lift its cash rate by a bigger than expected 50 basis points, said the Board discussed that the “current level of the cash rate is well below the lower range of estimates for the nominal level of the nominal neutral rate”.

The Board also considered that “if inflation expectations rise, the level of nominal interest rates required to return inflation to the target will be higher than otherwise”.

The neutral rate is the real policy rate that is neither expansionary nor contractionary.

It’s one benchmark for assessing the stance of monetary policy.

Soon after, RBA Deputy Governor Michele Bullock said Australian households are “well positioned” for rate hikes and indebted households will be “quite resilient to at least some rise in interest rates”.

In a Brisbane speech on the preparedness of households for interest rate increases, she concluded that “as a whole households are in a fairly good position.”

Ms Bullock said the household sector as a whole has large liquidity buffers, most households have substantial equity in their housing assets, and lending standards in recent years have been more prudent and have built in larger buffers for interest rate increases.

“Much of the debt is held by high-income households that have the ability to service their debt and many borrowers are already making repayments well above what is required,” she said.

“Furthermore, those on very low fixed-rate loans have some time to prepare themselves for higher interest rates.”

She cautioned that, while “in aggregate, it seems unlikely that there will be substantial financial stability risks arising from the household sector, risks are a little elevated.”

“Some households will find interest rate rises impacting their debt servicing burden and cash flow,” she said. “While the current strong growth in employment means that people will have jobs to service their mortgages, the way the risks play out will be influenced by the future path of employment growth. This, along with the Board’s assessment of the outlook for inflation, will be important considerations in deciding the size and timing of future interest rate increases.”

Asked about the neutral rate, Mr Bullock said it’s a “fair bit” higher than the current level and the Bank is focused on getting to a “more neutral” position.

As for the level, she referred to the RBA’s most recently published research on the topic, from 2017.

“We estimated – it is a wide range of estimates – but we thought it might (be a) real rate between half a percentage point and one-and-half percentage points,” Ms Bullock said.

“So somewhere in that range. That’s quite a range. But that’s actually only the real component.”

“The nominal rate which corresponds to that is going to depend on what inflation expectations are, and inflation expectations are very difficult to measure as well.”

“They are our most recent estimates for it, but it’s really really (SIC) difficult.”

“What we do know is that we are probably well below (neutral).”

The RBA’s discussion of the neutral rate of cash, implied it now believes it’s above the 2.6 per cent level that cash averaged in the 10 years to 2019, according to ANZ.

Minutes said: “Members observed that estimates of the nominal neutral rate were above the cash rate in the decade prior to the pandemic.

“This was a period when inflation was low, and potentially indicated limitations of the framework as a benchmark for the stance of policy.”

ANZ Head of Australian Economics, David Plank said the Deputy Governor’s reference to research that the neutral real rate was 0.5-1.5 per cent “implies a low-end of the range nominal estimate of 3 per cent if medium-term inflation expectations are well anchored”.

“This explains why the scenario work she referenced for the analysis in the body of her speech modelled a 300bp lift in the cash rate,” he said.

It came as ANZ sharply front-loaded its longstanding call for the RBA cash rate to exceed 3 per cent.

ANZ’s Mr Plank expects the RBA will take the cash rate target to a restrictive setting above 3 per cent by late 2022, more than 12 months earlier than his previous forecast, due to strong momentum in the labour market and the clear upside risks to inflation.

“We don’t think the RBA will be comfortable with policy merely getting to neutral by year-end given this backdrop,” he said. “Our expectation is that the RBA will deliver this via four more successive 50bp rate hikes in August, September, October and November.”

RBC chief economist Su-Lin Ong saw upside risk to her forecast of 2.85 per cent for the peak cash rate and the pace of tightening after the RBA minutes and the RBA Deputy Governor’s speech.