Raising interest rates was the RBA’s least-worst option
Australian borrowers let out a collective groan on Tuesday afternoon, thanks to the Reserve Bank’s decision to raise interest rates by a quarter of a percent. The sweet relief created by the interest rate cut cycle was short-lived.
The Federal Reserve’s decision to raise rates was ultimately the path least regretted.
While a month ago, the decision on whether interest rates would be kept constant or increased was a coin toss, the economic data especially over the last four weeks turned the scales upside down.
The evidence is now solid enough that the economy is overheating, thanks to household spending, investment and housing, and inflation is rising high enough to make our central bank’s board frown.
Of course, there were compelling arguments for the central bank to wait until the end of March to get a clearer picture of the economy; in particular, whether the inflation currently occurring is temporary.
Economists who support a less trigger-happy central bank argue it should take a wait-and-see approach on interest rates, arguing that a stronger Australian dollar acting as a brake on the economy reduces the need to act preemptively on interest rates.
But sitting on the fence comes with risks.
If the Central Bank does nothing and inflation gains serious momentum, the measures needed to reduce inflation will be more painful for debtors. It may result in more or larger rate increases over time.
Therefore, increasing interest rates by a quarter of a percent could be described as the path that would cause the least pain. This may turn out to be a Goldilocks move after all.
However, if the Central Bank raises interest rates again in the first half of this year – which many economists see as a distinct possibility – the hit to household balance sheets will be felt more severely.
(A quarter percent increase in rates would cost a borrower with a $750,000 mortgage about $110 extra per month.)
It is clear that interest rate increases polarize depositors and debtors. It is beneficial for those who have money in the bank, generally older and wealthier, who will earn additional income from their deposits.
But even among those with mortgages, there’s a wide gap between those struggling to pay their monthly interest and a larger group (more than 80 percent) who aren’t adjusting their payments as rates fall, instead building a buffer in their mortgage offset accounts.
This is the real reason why banks do not show a significant increase in mortgage arrears as interest rates rise.
Unfortunately, there is a smaller group of borrowers who struggle to meet their monthly interest bills. They are among the group feeling the real pain of the high cost of living and will find it even harder to manage their finances as the government’s support package for energy bills is introduced.
It is expected to have a net positive impact on earnings for the major Australian banks, which have all anticipated this latest increase. This was despite the risk that higher interest rates would negatively impact credit growth.
Meanwhile, a rate hike will either give Australia the title of ‘first mover’ among the world’s developed countries or turn it into a global pariah.
This will inevitably lead to criticism that our central bank is not doing enough to suppress inflation, which is set to rise in 2022 following the government’s intense Covid-19 stimulus.
The RBA increased the cash rate by 425 basis points between May 2022 and November 2023; this was less tightening than most other central banks did at the time.
This meant that growth slowed less than elsewhere, the unemployment rate rose only slightly, and inflation gradually fell. It has provided Australian borrowers with a degree of anesthesia for their household balance sheet pain.
Sure, the Reserve Bank of Australia had its soft landing, but what about the bump at the end of the tarmac?
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