The Reserve Bank of Australia (RBA) toned down its stance on monetary policy this month. While three economists from major banks predicted a 50bps increase, the central bank made a surprise move, raising the cash rate by 25bps to 2.60%.

AMP chief economist Dr Shane Oliver said the RBA appears to have already started slowing down on its upwards cycle.

“In justifying another hike, the RBA noted inflation is still too high and expected to rise further due to global factors and strong demand and that it’s important that medium term inflation expectations remain ‘well anchored’,” he said.

“We see another 25bps rate hike next month taking the cash rate to 2.85% which we still expect will be the peak in the cash rate, albeit the risk is on the upside to 3.1%. We still see rates falling late next year,” he said.

Dr Oliver said there are five reasons why the central bank’s move to go with a 25bps hike makes sense and why the end is near for the current hikes.

“But the 250 basis points in rate hikes over six months is still the fastest series of hikes since 1994, so it made sense to slow the pace down as it assesses the outlook for inflation and growth,” he said.

1. Economic impacts of monetary policy changes come with a lag.

The impacts from rate hikes are not immediate and the RBA is taking a careful approach not to over-stress the economy.

Dr Oliver cited the events in the late 1980s and early 1990s — unemployment rates kept falling over 1988 and 1989 but the RBA progressively hiked rates to 18%.

“But by then it was too late as the impact of past rate hikes hit the economy hard in 1990 and it went into deep recession, with the RBA then having to rapidly reverse course as unemployment surged,” he said.

“Of course, things were different back then with very low debt & very high inflation expectations resulting in much higher interest rates than are needed today — but the lags are still relevant.”

A possible rationale behind the RBA’s 25bps hike is to avoid the over-tightening similar to 1989 — this would give time for the lags to came into effect.

2. Borrowers are likely to be in significant mortgage stress later this year.

Rate hikes take up to three months to impact actual variable rate mortgage payments and several months to have a significant dent on spending.

The 250bps rate hikes since May are close to bursting through the 3% buffer the Australian Prudential Regulation Authority rolled out last year.

A study by Roy Morgan found that around 20.8% of mortgage holders or around 942,000 borrowers are currently classified as "at risk" since the first rate increase in May.

Dr Oliver said based on RBA analysis, more than a third of households would see a 40% increase in payments.

“This is about 1.3 million households and would cover those most likely to have to cut back their spending, like new homeowners often with a young family,” he said.

A PropTrack study showed that since April, borrowing capacities has shrunk by over 20% due to the rate increases.

3. Global inflationary pressures are easing.

The RBA is closely monitoring inflation not just in Australia but globally — business surveys indicate that the pipeline inflation indicator is well down from its highs.

“Consistent with this US money supply which surged ahead of the US inflation spike is falling. Combined this points to downwards pressure on US inflation, which looks to have peaked. Australia appears to be following the US by about six months, pointing to a peak in inflation here later this year,” Dr Oliver said.

“Related to this, medium-term inflation expectations remain reasonably low suggesting that the task of central bankers should be a lot easier than in the 1970s and 1980s.”

RBA’s central forecast is for the inflation to peak at 7.75% over 2022, above 4% in 2023, and 3% in 2024.

4. Australian experiences less inflation pressure.

Dr Oliver said there is no need the RBA to match other central bank rate hikes, given that inflation in Australia is lower than the 8% in the US and the 10% in Europe. Wages growth is also about half US levels.

5. Global recession risks are mounting.

The rising recession risks evident globally is also another reason why the RBA has scaled down on its rate hikes. Dr Oliver said there are several tell-tale signs of these risks.

“The 23% plunge in global share markets, falling commodity prices, central banks including the Fed willing to risk recession, the Fed’s record of tightening cycles ending in a crisis, the rising skittishness of financial markets, the deteriorating global growth outlook, domestically low consumer confidence, and rapidly weakening housing indicators warn of much weaker conditions ahead which will hit jobs and drive weaker inflation,” he said.

“Aggressively tightening into all this without pausing for breath risks knocking the Australian economy into a recession we don’t have to have.”

Photo by Nick Fewings on Unsplash.