How high can interest rates go up and when will they cause house prices to fall
This is the moment dreaded by all mortgage payers – what impact could an increase in interest rates have on house prices?
How high interest rates will go is not a question Australians have had to grapple with for a decade. Interest rates have been falling steadily since the RBA’s last hike in 2011. All the way down from 4.75% to 0.25%.
But now financial markets are pricing in a relatively steep sequence of interest rate hikes to a spot rate above 1% before the end of the year. Even a reluctant RBA has acknowledged that the cash rate may move much sooner than he recently expected.
Will this happen and how high will the RBA exchange rate be?
Whether the rate hikes will happen depends on a few crucial things that are going well for the economy. The first is that inflation and wage growth must both be above 3% on a sustained basis. Right now inflation is doing well but wages are lagging.
Business surveys suggest that wage increases are strengthening. However, two factors can mitigate this. The Omicron shock deprived companies of labor and may have triggered temporary wage increases due to shortages or overemployment.
Additionally, the Morrison government is targeting 200,000 foreign workers arriving by June through the reopening of the border, which will suppress wage growth, as it always does.
The second reason to doubt that the RBA will lift the cash rate this year is the fact that Australia is lagging behind global monetary tightening.
In China, last year’s interest rate hikes – which were prudently designed – have already hammered its real estate market and it is now exporting a a lot of deflation which will arrive in Australia in due course.
In the United States, future interest rate hikes by the Federal Reserve have already caused all sorts of problems for the financial markets. The Fed always breaks something in the markets, but usually not before it even begins.
This cycle seems particularly sensitive given the very high debt and expensive assets. The Federal Reserve could trigger equity and credit crashes that would land on Australian economic activity and kill inflation before the RBA needs to pull its own trigger.
Assuming this does not happen, how high will the RBA raise the cash rate? Like the United States, Australia has highly valued assets in real estate, stocks and bonds due to historical levels of debt.
This means the Australian economy is more sensitive to interest rates than ever before. Previously, asset prices lagged the economic cycle. But since we have “financialized” everything – that is, we are putting debt and not productivity at the center of economic growth – asset prices now drive the economy, and if they fall, they will. will train with them.
For example, the RBA’s own house price model suggests that just four interest rate hikes would drop house prices by a quarter to a third. It’s a non-starter given that it would wipe out both economic activity and inflation.
So what will be the maximum interest rate? According to the RBA, the break-even interest rate is 2.5%, but that doesn’t fit very well with its property price model, does it?
So even the central bank does not have a good idea of how high interest rates will need to be in today’s new “normal” environment.
Matters are made even more complicated by the shift to fixed rate mortgages in the Covid cycle. Some $500 billion in mortgages will already be reset over the next three years, rising from less than 2% to almost 4% by the end of the honeymoon periods.
That’s a lot of built-in clamping.
So don’t be scared off by the more hawkish interest rate forecasts, which include the credit markets. If the RBA raises interest rates, it probably won’t get very far before asset prices force it to pause. Indeed, if recent cycles are anything to go by, the spot rate will barely take off if it rises.
This is the way of the heavily indebted and financialized economy.
David Llewellyn-Smith is chief strategist at MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economics editor of The Diplomat, Asia-Pacific’s leading geopolitical and economic portal. He is co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.