In an eye-opening address at the Bloomberg event in Sydney on 11 October, Christopher Kent, Assistant Governor of the Reserve Bank of Australia (RBA), dissected the intricacies of Australia’s recent cash rate hikes. As of May 2022, the country has witnessed a 400-basis point uptick in cash rates. What does this really mean for the economy and the average Australian? Quite a lot, according to Kent, as he systematically peeled back the layers of Australia’s monetary policy to reveal its tangible impacts on demand and inflation.
Firstly, Kent emphasized the “cash-flow channel.” This is the most immediate mechanism by which higher interest rates take a bite out of disposable income, by increasing interest payments for those holding debts. While borrowers with variable-rate debt feel this almost instantaneously, others with fixed-rate loans only get hit later. According to Kent, households and businesses are already cinching their financial belts, reducing demand and lowering inflation in the process.
Banks also play a pivotal role in the unfolding scenario. When they borrow in the overnight market, the rate they pay is closely tethered to the cash rate. As this rate rises, so do banks’ funding costs, which are then promptly passed on to borrowers. Australian banks have a keen focus on variable-rate lending, making the impact of these changes swift in comparison to countries like the United States, where long-term fixed rates dominate.
On the flip side, depositors have seen a modest increase in their rates. Australian banks have passed on roughly 75% of the rate hike to deposit rates. In contrast, this is significantly higher than what has been seen in countries like New Zealand and the United States, where only around 50% and 35% have been passed on, respectively.
Kent offered a holistic view of how the cash rate operates through five key channels: the cash-flow channel, the intertemporal substitution channel, the asset-price channel, the credit channel, and the exchange rate channel. For instance, households will find that mortgage payments will consume a larger share of their disposable income, rising from 7% to nearly 10%, a spike not seen since 2008. In the business arena, higher levels of debt have prompted firms to reduce investment, estimated to be around 4% lower in the next two to three years due to the rate increase.
Despite the accumulation of household savings during the pandemic, higher rates could deter the rate at which these savings are spent. Kent noted a recent rebound in asset prices, likely influenced by demographic factors like population growth and a lack of new construction.
Higher interest rates have also trimmed the borrowing capacity of the typical Australian household by about 30%, affecting both demand and the rate of growth.
The Assistant Governor left no stone unturned in offering a nuanced explanation of how cash rate movements ripple through the economy. It is a meticulous look into the financial dynamics that could shape Australia’s economic future.
“The exchange rate channel can be important, particularly for a small open economy like Australia,” Kent said. He explained how the appreciation of the Australian dollar directly contributes to lower Australian inflation through decreased prices for imports. However, he also cautioned that while Australian interest rates have increased to tackle inflation, global interest rates have followed suit. Consequently, the Australian dollar has depreciated by just over 2% since May 2022 on a trade-weighted basis, also impacted by concerns over China’s economic outlook.
Kent closed by stating, “The lags of transmission mean that some further effects of rate increases to date are still to be felt through the economy, which will provide further impetus to lower inflation in the period ahead. Meanwhile, the Board is paying close attention to economic developments here and overseas, and some further tightening of monetary policy may be required to ensure that inflation, which is still too high, returns to target in a reasonable timeframe.”
As we navigate this tightrope of economic instability, Kent’s insights serve as a guide to understanding the subtle and not-so-subtle shifts that are redefining Australia’s economic landscape.
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