June’s interest rate rise and what it means for you
I’ve worked in a few share market dealing rooms.
You can hear a pin drop in the seconds leading up to a Reserve Bank interest rate decision.
Immediately after an RBA announcement, there’s an audible “whoa!”
Tuesday afternoon would have been no different.
The drama would have played out across banks, investment banks and stockbroking firms across the country.
This chart shows what those financial market participants did next.
So, why did the RBA go further than expected in raising rates by 50 basis points — half a percentage point?
Let’s explore that and what it means for you.
All about inflation
The Reserve Bank has an inflation target band of between 2 and 3 per cent.
For those who don’t follow the daily and monthly goings-on of the Reserve Bank, this means — let’s be honest — nothing.
It is, however, crucial to understanding why the central bank is now tightening monetary policy.
It’s a “band” in which the bank believes inflation is neither too hot nor too cold and is consistent with price rises in the economy that are essentially benign: they won’t hurt anyone too much.
Inflation has not only moved outside this band, but it’s now potentially well beyond it.
“Inflation in Australia has increased significantly,” RBA governor Philip Lowe said.
“While inflation is lower than in most other advanced economies, it is higher than earlier expected. Inflation is expected to increase further, but then decline back towards the 2–3 per cent range next year.”
Allow me to paraphrase: “Ahem, OK, so inflation seems to be running away a bit. Here’s a rate hike surprise to rein things in a bit.”
BetaShares chief economist David Bassanese uses slightly stronger language: “The Reserve Bank of Australia has decided to inflict shock and awe on the economy today, no doubt with a view to eliminating any lingering complacency with regard to the inflation outlook.
“Indeed, today’s decision is a bolt from the blue and stands in marked contrast to the RBA’s recent soothing words with regard to the outlook.
“It is now acting out of clear alarm and is not frightened to show its alarm.”
Wage price spiral
It’s all a bit confusing though.
Why?
Well, you could easily argue that the price pressures in the economy aren’t connected with the sorts of forces that would be “tamed” with tighter monetary policy.
For example, petrol price spikes and higher energy bills are related to the pandemic and geopolitical tensions. There’s not much the Reserve Bank can do about that.
If anything, higher mortgage borrowing costs and rents only add to cost-of-living pressures.
But David Bassanese reckons the Reserve Bank is looking beyond all of that and sees the potential for inflation (prices) to rise significantly higher than now. Yes, much higher still.
“[The RBA] has clearly heeded the lessons of the US Federal Reserve which arguably waited too long to lift interest rates as US inflation lifted last year — and is now at risk of having to create a US recession to get America’s inflation genie back in the bottle.”
Is Australia different to the US?
The difference between the United States and here in Australia is that American wages are rising at a very healthy pace.
Wage pressure in Australia, at 0.7 per cent over the March quarter, is still relatively subdued.
But with a tighter labour market, and evidence businesses are basically passing on just about all higher costs onto customers, the fear is that a wage price spiral will ensue.
“The RBA is clearly concerned that a tight labour market together with already high energy and commodity-driven consumer price inflation could lead to a lift in inflation expectations and a potential “wage price spiral”, Bassanese argues.
The reality
The reality though is that wage growth caps still exist across the states and territories for public sector employees.
New South Wales has the strongest cap at 3 per cent (announced yesterday). That’s still well below the increase in the cost of living.
And the evidence from the latest national accounts shows workers are taking a record low share of national income. The vast bulk of economic growth is being absorbed by firms in the form of profits.
The Reserve Bank sees this improving.
“The Bank’s business liaison program continues to point to a lift in wages growth from the low rates of recent years as firms compete for staff in a tight labour market,” Dr Lowe said
That may go some way to explaining why the stock market reaction to the news of the surprise rate hike was so savage.
That is, investors don’t buy the Reserve Bank’s rose-coloured view on wages and fear the economy, and company profits, are about to take a hit.
What about the property market?
Well, again, the Reserve Bank believes households can cope.
“The household saving rate also remains higher than it was before the pandemic and many households have built up large financial buffers.”
Growth set to slow
The share market reaction points to the Reserve Bank’s decision putting a real dampener on growth.
Economists believe if the RBA sees signs unemployment is rising, perhaps with the potential for it to rise back above 4 per cent, it will stop tightening … but who knows?
The risk is that it keeps tightening, the economy stalls, unemployment rises and inflation doesn’t budge. Economists call that stagflation.
That’s a real risk because one can argue the economy isn’t in fact particularly strong right now – because a big proportion of economic growth is being generated by consumers dipping into their savings — and the rate hikes won’t materially influence the price pressures in the economy.
The Reserve Bank is looking to shake the economy up, let go of its extreme stimulus and move forward to normalise rates.
There’s a real risk the economy simply isn’t ready for that yet.
