Earlier this week, the minutes of the Reserve Bank of Australia’s (RBA) meeting on 4 July were released, revealing that the RBA’s estimation of the ‘neutral real interest rate’ is 3.5 per cent.
The ‘neutral real interest rate’ – the rate at which output growth is at potential and inflation is stable – is therefore 200 basis points higher than the current level of 1.50 per cent.
"All estimates of the neutral real interest rate for Australia suggested that monetary policy had been expansionary for the previous five years or so," the minutes read.
The cash rate has been at its record low level for almost a year, following the Reserve Bank’s decision to drop the rate to 1.50 per cent in August 2016 to provide “sustainable growth in the economy and achieving the inflation target over time”.
However, ME has warned that, as the RBA’s neutral real interest rate is projected at 3.5 per cent, this could soon lead to the bank hiking the cash rate.
It argued that an increase to 3.5 per cent would boost average mortgage rate from 5.3 per cent to more than 7 per cent, adding $520 per month to a loan average of $400,000.
According to ME’s head of home loans, Patrick Nolan, although interest rates have been dropping steadily since 2011, this can easily shift at any given time.
“Banks apply ‘stress tests’, typically around 2-3 per cent above the advertised rate when assessing loan applications to ensure customers can comfortably repay in higher rate environments,” Mr Nolan warned.
However, several economists have suggested that the disclosure of the RBA’s neutral real interest rate does not reflect a shift in monetary policy just yet, adding that it is not yet economically justifiable to have a neutral rate.
Further, while the RBA has revealed what its neutral real interest rate is, it has not provided any notion of how long it might take to increase the official interest rate from its current low.
Earlier this week though, there were suggestions from economists that mortgage rates could face “upward pressure” from other sources, as the prudential regulator told banks to hold more capital to meet “unquestionably strong” benchmarks.
[Related: Rate hikes to follow APRA’s latest move]