Are we near the peak of the interest rate cycle?
We know that the Reserve Bank Board decided to increase the cash rate by 50bps to 2.35% at its September meeting.
But the RBA recently signalled that the ‘normalisation’ phase of their rate rises is over.
Note: RBA hikes 50bps again but drops reference to ‘normalisation’
Bill Evans, Chief Economist of Westpac recently made the following commentary in Westpac's Market Outlook report:
He said:
The most important change in the Governor’s decision statement is the description of the tightening cycle.
In previous Statements, he referred to the rate increases being “a further step in the normalisation of monetary conditions”.
In the latest decision statement, this ‘normalisation’ note has been removed.
Normalisation can be interpreted as the process of moving policy settings towards neutral.
In previous speeches, the Governor has estimated ‘neutral’ as being at least 2.5%.
In not referring to this move as a step towards ‘normalisation’ we can, arguably, conclude that consistent with the 2.5% estimate, the Governor believes the policy is now neutral.
It is Westpac's view that policy should quickly move to neutral and then move more slowly as it traverses through to the ‘contractionary zone’.
That slower pace would imply a step back to 25bp moves going forward.
Some support for the concept of being a little more cautious with rate moves is provided in the comment:
“The full effects of higher interest rates yet to be felt in mortgage payments.”
Note: Further tightening is required but a slower 25bp pace makes sense from here given uncertainty and ‘treacherous lags’ in a system that operates through multiple channels
The Governor gave further support to a slowdown in the pace of increases in a speech two days after the Board meeting where he noted:
“We are conscious that there are lags in the operation of monetary policy and that interest rates have increased very quickly… the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises.”
Note that the decision statement also notes:
“The Board expects to increase interest rates further over the months ahead”.
Maintaining a 50bp pace when there are lags involved, particularly with respect to the impact of a heavily indebted household sector, would seem to be unnecessarily risky.
The best approach, now that neutrality has been reached, is to maintain the emphasis on inflation being the central commitment while backing that up by continuing to tighten policy.
During the Q&A session following the Governor’s speech on September 8, I proposed that if a handbook existed for central bankers, it would recommend rapid moves to normalise rates be followed by a slower approach as the central bank considers the impact of moves given ‘treacherous lags’ in the system that can see the pressure build-up and release quickly when rates move so quickly.
Consideration of lags is particularly important for Australia given the high level of household debt on floating or short-term fixed rate terms – the rate rise effect on household cash flows can be much more potent than in the US for example, where mortgages are typically on fixed rates that run for 20–30 years.
And remember that even though only one-third of households have a mortgage, rising rates impact through a variety of other channels including:
- cash flows for non-mortgage borrowers;
- the indirect effects on rental payments for tenants as investors respond to higher funding costs;
- negative wealth effects of falling house prices, which affect outright property owners as well as owners with a mortgage;
- higher borrowing costs for business; and deeply pessimistic confidence.
Note: Downgraded near-term path for AUD as a clear signal on inflation and rate risks takes longer to emerge
We have lowered our profile for the Australian dollar against the USD.
We now cannot see that lift to USD0.73 over the course of the remainder of 2022.
Our end-year target has been lowered to USD 0.69.
We anticipate significant volatility over the remainder of 2022.
Markets will remain risk averse until they can see the prospect of a clear downward trend in inflation and the peak in interest rates for central banks.
That is unlikely to emerge over the course of the remainder of 2022.
In contrast, we continue to expect the AUD to be strongly supported against the USD in 2023 with a USD 0.75 target.
That is because we do expect a steady emergence of that confidence around inflation and rates in 2023.
Note: We still see a strong rally to USD0.75 in 2023 but volatility will persist until several big issues are clarified
As central banks go on hold; inflation eases and markets look to rate cuts in 2024, risk assets, including the AUD, will be better supported.
But, for now, the ‘safe-haven/risk off’ attraction of the USD appears set to be sustained for longer than we had expected, while some of the supportive factors for the AUD we had anticipated in 2022 appear to be much more uncertain.
For example:
- markets are pricing in a wider interest rate differential between AUD and USD than we currently expect;
- China’s progress in stabilising its property market has been slow with more setbacks to reopening from the latest COVID lockdowns;
- and uncertainty around energy security in Europe is weighing heavily on the outlook for the Continent.
In 2023 we expect these issues to be clarified but the outlook for 2022, when markets will not be able to take comfort from central bank certainty, is going to be volatile and not supportive of any sustained upswing in the AUD/USD.
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Sharp slowdown in growth in 2023
Note: A solid growth performance in Q2 was driven by strong household spending on discretionary services
The Australian economy expanded by 0.9% in the June quarter for annual growth of 3.6%.
For 2023 we expect growth to slow to 1.0%.
That solid growth in the June quarter was driven by strong household spending (around 54% of GDP) as the reopening of the economy saw a further boost to expenditure, particularly on discretionary services.
This was accompanied by a substantial fall in the still elevated savings rate.
We had anticipated growth in household spending of 2.6%, compared to the actual result of 2.2%.
But spending growth in the March quarter was revised up from 1.5% to 2.2%, confirming our positive view of the household sector.
The detail around household spending was also in line with our thinking – the savings rate fell from 11.1% to 8.7%, effectively freeing up $7.6bn to finance the additional $10.8bn in spending during the quarter.
Discretionary services boomed:
- transport services up 37%;
- hotels, cafés, and restaurants up 8.8%;
- and recreation and culture up 3.6%.
But residential construction contracted by 2.9% and non–residential construction (private and public) was down by 1.8%.
This unexpected contraction in construction (subtracted 0.3ppt from growth in the quarter) represented around a 0.6ppt turnaround from our prior.
Note: But reopening effects to fade from here as rapid-fire RBA rate hikes start to impact setting the scene for a sharp slowdown in 2023
Looking forward, we expect to see a slowdown in the growth rate of consumer spending in the September and December quarters.
The reopening effect will begin to fade, and the recent interest rate increases will start to impact households.
There were two rate hikes in the June quarter (0.25% in May and 0.5% in June).
The impact on household finances from those two rate hikes in the June quarter will have been minimal.
But by the September and December quarters, which have seen a rate of 0.5% increase in July; August; and September the impact will be substantial.
We expect the cash rate to rise by a further 100bps, to a peak of 3.35% in February 2023.
Although around one-third of households hold a mortgage; one third are renters, and one third own their properties outright, rate increases impact all groups through a range of channels – the cash flow of borrowers; the indirect impact from investors who pass on higher funding costs to renters, particularly as rental vacancy rates are near record lows in many cities and regions; the wealth effect of falling house prices on those who own their properties outright and borrowers; and the recent collapse in Consumer Confidence.
Nationally, house prices have already fallen by 4%, with our forecast of another 12% likely to follow through to the second half of 2023.
The contraction in construction in the June quarter has been attributed to weather delays and supply constraints.
We expect to see construction lifting modestly through the second half of 2022 reflecting the build-up in the construction pipeline.
A further contraction can be expected in 2023 as rising rates weigh on demand – effectively reducing the pipeline.
Reflecting on these changes, we have lowered our growth forecast for 2022 from 4.4% to 3.4%.
Note: We reaffirm our downbeat view for growth to decelerate from a 3.4% pace in 2022 to a forecast 1% in 2023 that includes consumer spending growth slowing to 1.2% and a decline in home building activity, as property prices slump
Growth in consumer spending during 2022 is expected to slow from 4.4% in the first half of the year to 1.8% in the second half.
But with the expected recovery in the construction cycle, we see dwelling construction lifting by 5.4% in the second half of this year, a turnaround from a contraction of 3.4% in the first half of 2022.
Overall, with the expected short-term recovery in the construction cycle partially offsetting the slowdown in the pace of consumer spending, we expect growth in the second half of 2022 to hold around the same 3.2% annualised pace as we saw in the first half – albeit conditions in the final quarter of 2022 are likely to more subdued than those during the September quarter.
We have not changed our downbeat view for growth in 2023.
We expect GDP growth in 2023 to slow to 1.0% with private domestic demand growth slowing to 0.2% (a sharp deceleration from an expected 5.4% expansion in 2022).
We cannot rule out a negative quarter of growth in 2023 but do not expect a classic recession.
Consumer spending growth is expected to slow from 6.3% in 2022 to 1.2% in 2023; business investment growth will slow from 5.8% to -1.0%; while dwelling construction growth will slow from 2.0% to -4.0%.
That slowdown in consumer spending growth will include a very modest further fall in the savings rate from 3.6% by the end of 2022 to 2.3% through 2023 - below the “equilibrium” rate of 6%.
This will see the stock of “excess savings” accumulated during the pandemic, currently at $275 billion, wound back to around $200 billion by the end of 2023.
The economy in 2023 will experience the full accumulated effect of the lift in the cash rate from 0.1% in April 2022 to 3.35% in February 2023.
Other negatives for growth in 2023 are:
- a total fade out of the “reopening“ effect;
- a limited further fall in the savings rate to below equilibrium as households continue to draw down those excess savings albeit at a slower pace than in 2022;
- a rise in the unemployment rate from 3.0% to 4.2%;
- and a fall in house prices from peak to trough of around 16%.
Guest Author: Bill Evans, Chief Economist, Westpac
