The Reserve Bank of Australia’s (RBA) aggressive cash rate hikes are starting to have the desired effect on inflation, with borrowers being forced to dramatically tighten their purse strings.
Assistant Governor of the RBA Christopher Kent, speaking to Bloomberg, said that tighter monetary policy was slowing growth in demand and bringing it into better balance with supply – contributing to the decline in inflation.
He said the 400 basis points of interest rate hikes were working, however, the full impact was yet to be felt.
“These and the other channels of monetary policy are slowing the growth of demand and contributing to a decline in inflation,” Assistant Governor Kent said.
“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.”
Assistant Governor Kent said that one of the reasons inflation has been hard to control was due to the large portion of borrowers who took out low fixed-rate loans during the early part of Covid.
He said as these borrowers roll off onto higher variable rates, this will have a lagged effect on inflation and help to further reduce demand.
“Around half of all loans that were fixed at a low rate have now rolled off, and most of the rest will do so over the next 12 months,” he said.
“Required mortgage payments are at a record share of household disposable income and will rise further as more fixed-rate loans expire.”
Assistant Governor Kent said, since last May, required household mortgage payments had risen from about 7 per cent of household disposable income to almost 10 per cent, which is above estimates of the peak reached in 2008 when the cash rate was 7¼ per cent.
And for those households with a large mortgage, required payments are a much higher share of their income.
“Many borrowers have had to cut back on spending to meet higher mortgage payments, while also feeling the pain of rapidly rising living costs,” Assistant Governor Kent said.
He said the RBA predicts that with a cash rate at 4.1 per cent, household spending would decline by between 0.4 per cent and 0.8 per cent a year.
He said it was also putting pressure on retailers to cut their prices.
“The effect of slower demand growth on inflation is now building,” he said.
“For example, we are hearing in liaison that a range of retailers are discounting prices in the face of weak consumer spending.”
Assistant Governor Kent said there were a number of ways in which higher interest rates reduced demand throughout the overall economy.
He said the main way was through the cash flow channel which reduced household income for borrowers.
However, with its prevalence of variable-rate mortgages and short fixed-rate terms, the Australian economy is a lot more responsive to higher interest rates that force them to pay more on their debt.
Other ways higher interest rates lower demand also come from the intertemporal substitution channel, the asset-price channel, the credit channel and the exchange rate channel.
According to Assistant Governor Kent, for households, higher interest rates provide an incentive to save more today and postpone consumption and dwelling investment until another time.
He said higher interest rates also tend to make lending more risky, especially to lower net-worth borrowers.
Another way higher interest rates reduce demand is because higher interest rates increase the value of the Australian dollar relative to other countries.
He said this time around that has happened because other countries have also been raising rates aggressively.
Assistant Governor Kent said in Australia the cash-flow channel will continue to be the main lever for the RBA, and there might be more work to be done.
“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,” he said.