Prepare for another hit.
When Reserve Bank heavyweights gather around the board table in Martin Place tomorrow, the question will not be whether to raise rates, but how much.
The consensus is that we will be hit with a fourth consecutive double increase, although some forecasters, such as Saul Eslake, believe that the RBA this month will begin to moderate the increases, reducing them to increases of 0.25 percentage points.
Having come to the rate-hike party too late, the Reserve Bank is under increasing pressure from outside forces to maintain momentum, especially since US Federal Reserve chief Jerome Powell declared a little over a week ago its intention to continue the fight against inflation.
Since that speech, already skittish financial markets have turned around.
Just when they thought the worst might be behind them, they were forced to reassess their predictions about the level at which interest rates would peak, with much higher forecasts sending stocks and bonds lower.
Wall Street last week lost about 7 percent, while our market fell about 4 percent with a couple of days of particularly intense selling.
At just the right time, the decline in our housing market accelerated last month, falling at the fastest pace in 39 years. It now stretches across the country with the regions to the south and all capitals except Darwin in decline.
Asset markets are falling globally and central banks, led by the US Federal Reserve, don’t seem too concerned.
That change in attitude is significant. Having spent the past 20 years jumping to the defense of financial and property markets, cutting rates at the slightest hint of trouble, the world’s largest central bank has suddenly decided to play hardball with a steely determination to stamp out inflation. first and worry about recessions later. .
If it’s going too hard it’s too early to tell. But his actions will have repercussions globally, even here.
How far will the RBA hikes go?
Another double increase tomorrow will take the official cash rate to 2.35 percent. From a starting point a touch above zero in May, the pace of rate hikes has been incredible, unlike anything we have seen in decades.
If you believe the money markets, the RBA will quickly move towards 4 percent, although the speed at which the money markets change their forecasts is impressive.
Sensible commentators, including Eslake and Gareth Aird of Commonwealth Bank, believe we have seen the worst, that while further rate hikes are on the way, the pace will slow significantly.
There is a simple explanation for their way of thinking. It takes a long time for the full effect of changes in interest rates to manifest. This is known as the delayed effect.
While we have seen a drop in house prices, because banks are no longer prepared to lend the kind of money they once were, there have been few early signs of a slowdown in household spending.
One reason is that it takes a while for banks to push rate changes to their customers. Another is that it takes some time before consumers start to pull back on their spending. The tide initially turns gently before receding at a faster rate.
There are other factors too. A host of new entrants to the housing market have taken out fixed-rate mortgages, which roll over for the next 18 months, so the impact of higher interest rates has effectively been delayed.
The RBA is now at a point where it needs to be careful. If you continue to bash mortgage holders and business owners with rapid rate increases, you may find by Christmas that you’ve overdone it and may need to reverse course.
That would be a disaster. The idea behind monetary policy is to keep the economy in balance, add a touch of throttle when things are slowing down, and gently apply the brakes when it appears the economy is overheating.
Hitting the brakes, as is being done now, is a dangerous tactic, one that could easily go wrong. And let’s face it, the RBA hasn’t had a great track record lately when it comes to picking cycles.
The Currency Riddle
The Australian dollar has been like a cat in the box lately bouncing between US72c to below US68c.
The slowdown in China is one factor. Iron ore prices have stopped boiling in recent months.
But the biggest influence has been the strength of the dollar. As the Federal Reserve raised interest rates, the US dollar soared. In June, the United States hit borrowers with a triple increase that pushed the cash rate up to 2.5 percent.
The next US hike could very possibly be another triple whammy, sending rates as high as 3.25 percent. Such a move would light a fire under the dollar and see the Australian dollar sink.
That is something that would be of great concern to the RBA. A weaker currency is inflationary, because it costs more to import goods. Given that the whole focus right now is on stamping out inflation, the temptation inside Martin Place would be to ensure that our currency doesn’t weaken too much.
There is a danger that the RBA will get sucked into the vortex and push rates higher than they should just to support the currency.
Those considering a stay abroad may disagree, but a weak currency is not all bad.
It makes local industry more competitive and boosts exports, which helps keep unemployment low.
Can we avoid recession and maintain full employment?
If there’s one really bright spot for the economy right now, it’s jobs.
With an unemployment rate of just 3.4 percent and wage growth well below that of the US, there is a genuine feeling that we may have a once-in-a-lifetime opportunity to return to the days of ” full employment” after the war.
For half a century, it has been believed that we need a group of unemployed to keep inflation in check. It’s a theory that evolved in the wake of the burst of inflation in the 1970s, that we needed about 5 percent of the workforce to be out of work to ensure a plentiful supply of workers.
The practice is so ingrained in economic theory that it even has its own acronym. It is called NAIRU, the unemployment rate that does not accelerate inflation.
The theoretical rate has varied over the years and, more recently, has decreased. From 5 percent, it dropped to four a few years ago and is now at three.
Whether that trend can be sustained is highly uncertain, as the intention behind rapid rate increases is to accelerate growth and reduce demand, which then hurts jobs.
The economy is already slowing rapidly. House prices are falling at a breakneck pace, particularly in eastern states, which will lead to what’s known as a “negative wealth effect.” If everyone feels poorer, they will spend less.
Construction approvals last month fell nearly 18 percent, while new home loans fell nearly 8.5 percent in July.
This is not the kind of “steady on the fly” strategy that central banks have long adhered to.
Once tomorrow’s rate hike is out of the way, RBA chief Philip Lowe will need to tread carefully.
It clings to the belief that there is still a “narrow road” to economic Nirvana, that we can beat inflation and not end up in recession.
But the road is getting full of obstacles.
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