There has been a great deal of speculation around the movement of the RBA cash rate in 2018, with one publication showing 81 per cent of its panel predicting a rise as early as May 2018. While there is no doubt the RBA would relish the opportunity to start the process to “normalise” interest rates, an event that would usually signal economic conditions were stabilising towards growth, it is simply too early to make that call.
Interest rates are known as the 'blunt instrument' for controlling inflation. By raising interest rates central banks promote savings and reduce expenditure, which dampens price rises (deflation). Lowering interest rates is designed to have the opposite affect by negating the benefits of saving, promoting spending and stimulating economic growth. These are the domestic affectations of interest rate manipulations.
But any ‘normal’ economic adjustments to interest rates as a tool for managing inflation went out the window as soon as governments began pumping ailing economies with cash through quantitative easing. This, together with artificially low rates of interest, has led to an abundance of credit that led to one of history’s greatest economic follies with out of cycle increases in asset prices in markets otherwise suffering economic downturn.
With recent falls in key stock indices, perhaps we are at least seeing the beginning of a correction in stock prices. In Australia investors have long supported stocks with P/E ratios of 15 times plus, but have only done so because of an expectation of share value growth.
Of course, this is indicative of a bull market without underlying fundamentals. With rental yields as low as 2 per cent in parts of the property sector, the same is true to a certain degree in the real estate market. The bubble is growing and surely has to burst.
While there has been no quantitative easing in Australia, rates of interest have been historically low and credit has been easy to come by. This has led to a meteoric boom in the property market. The Australian Government has made it clear that it wants to see a cooling off in real estate prices and its strategies have begun to bear fruit with slight devaluations in major cities. This follows manipulations of mortgage rates for investor loans and commercial mortgages.
The government wants this ‘correction’ in asset prices to be controlled and this is a tightrope the RBA must walk while household debt is nearly 200 per cent of disposal income. Australians are effectively living on credit.
To our mind, any urgency to normalize interest rates is a falsehood. There can be no ‘normalizing’ of rates in a market that has bucked the global trend and seen massive asset value increases driven by outrageously high levels of domestic debt. This is not economic growth, it is a vacuous spending spree with other peoples’ money.
It seems more likely that the RBA is desperate to raise interest rates so it has somewhere downward to go if, but more likely ‘when’ Australia suffers economic recession. This plan is flawed because the market is already saturated with a debt that it desperately needs to shed before any stimulus in spending could occur again.
The real challenge to the RBA though is the property market and extent of banks’ exposure to mortgage debt. Here, any increase in interest rates will be passed on and simply add to mortgage stress.
The RBA has to be acutely mindful of this and the fact that any upward movement of interest rates has to be balanced against a backdrop of high household debt, precarious (if not government-tampered) unemployment figures and low wage rise increases. And this is a precarious house of cards. If interest rates rise too rapidly, mortgage affordability will reduce, leading to a corresponding increase in mortgage defaults. Defaults cause distressed property sales and this puts a downward pressure on property prices. Downward pressure on property prices further exposes the banks and causes them to increase margins against losses and this leads to more mortgage stress, more defaults and more downward property price pressure. It is an economic death spiral.
Let us not forget too, that foreign currency values affect the manipulation of interest rates. Here the governor of the RBA has told us he “won’t be pressured to raise rates” by rises in interest rates overseas. But he might find himself unable to resist if the Australian Dollar tanks as investors take flight in search of stronger interest yields.
The RBA faces an impossible task in wanting to raise interest rates to provide a move towards normalized rate. It knows that by so doing it risks precipitating a rapid asset devaluation that will leave the banks uncontrollably exposed to an overheated property market funded by borrowers stacked to the gunwales with credit! But if it does nothing and recession comes knocking, it has little left to stimulate growth. The cupboard is bare!