Not another attempt to come the raw prawn with us on Australian interest rates! Shane Oliver

GUEST OBSERVER

Not another attempt to come the raw prawn with us on Australian interest rates!

The financial market reaction to the minutes from the last RBA meeting was way over the top. Don't read too much into them.

I must admit to finding the periodic discordance between the post meeting statement and the minutes a bit disturbing - surely they relate to the same meeting and so should leave the same impression.

It does make me wonder though whether the high level of RBA communications could just be adding to noise and confusion around interest rates at times. Mind you, this is a much bigger problem in the US. 

But back to where interest rates are headed...the minutes certainty did sound a bit more upbeat than the initial post meeting statement about growth and wages. But the bit that caused most excitement was the reference to a 3.5% neutral rate of interest, ie the rate of interest consistent with growth at potential, inflation at target and which neither causes the economy to accelerate or decelerate.

Some have interpreted this as indicating that a series of eight quarterly rate hikes of 0.25% are imminent. This is very doubtful.

First, the neutral rate discussion looks to have been just a regular “deep dive” into a key issue and so as Deputy Governor Guy Debelle pointed out “no significance should be read into the fact the neutral rate was discussed” at the last meeting. 

Second, the neutral rate is a rubbery rather academic concept, a bit like the non-inflation accelerating rate of unemployment (NAIRU) and the “output gap”. In theory it should be around long run potential nominal growth, but it can move around a lot given attitudes to debt and debt levels, the gap between the rates bank lend at and the official cash rate, inflation expectations, uncertainty about what potential growth is, etc.

At the Fed, they refer to a long term neutral rate (seen to be around 3% at present) and a short term neutral rate with Fed Chair Yellen recently saying it was already close to neutral with the Fed Funds rate at just 1-1.25%! So while a comparison to some neutral rate may be of use in assessing whether policy is easy or tight it’s not a firm target that central banks head for.

Third, for what it’s worth our assessment is that because of higher household debt to income levels and higher bank lending rate spreads the neutral rate is around 2.75%.

Fourth, a rise in the cash rate to 3.5% over the next two years if passed on in full would push the ratio of household interest payments to household disposable income from 8.6% currently to around 12%. This would be well above the average ratio of 9.6% since 2000, above the 2011 peak of 11.4% and towards the pre GFC peak of 13.2%, both of which saw hits to consumer spending – see the next chart.

The hit this time would likely be greater as unlike a decade ago households lack the optimism to take on more debt to cover higher interest payments (remember the ATM in the lounge room!). So the 3.5% of income hit to spending power would likely take a big chunk out of consumer spending. Of course these numbers are averages - for those households with a mortgage the interest payment to income ratio would be around three times higher and in Sydney and Melbourne it would be even higher again.

Which all suggests that in the absence of much stronger economic conditions rates won’t be increased by 2%.

Finally, heightened rate hike expectations have already pushed the $A above $US0.79 and a cash rate of 3.5% would likely see it soar, exacting another round of damage on the economy just at a time when we still need a lower currency to offset the impact of still falling mining investment.

Reflecting all these influences, when it does come time to start raising rates the RBA won't be on autopilot on its way up to 3.5% but rather will be incremental, ie hike 0.25% and then wait to assess the impact. And as we have seen with the Fed the process is likely to be very gradual and we doubt that rates will be able to go as high as 3.5% any time soon as the RBA won't want to crash the economy.

As to the timing of the first rate hike, while the RBA's upbeat view suggests the risk of an earlier move, our view remains that it won’t occur until late next year. While jobs growth and business confidence are good other indicators are far more mixed - particularly around the consumer, wages and underlying inflation.

It’s worth noting that Deputy Governor Debelle also pointed out that: rate hikes by other central banks do not mean that the RBA has to raise rates too; interest rates in both the US and Canada remain below those in Australia; a rising $A works against the benefit of stronger global growth; and that a lower $A “would be helpful”. It’s hard to see any sign of an imminent RBA rate hike in any of this.

SHANE OLIVER is head of investment strategy and economics and chief economist at AMP Capital and is responsible for AMP Capital's diversified investment funds.