Australia has an inflation problem, and higher interest rates are the only way to fix it
Yesterday’s inflation data heralds good and bad news for Australian households.
It almost certainly means interest rates are heading higher. Probably at least two more hikes – or half a percentage point in total – are left in the current monetary policy cycle. We may be spared too many more by the strong currency and the fact that the economy’s sensitivity to interest rate changes is much greater than it was in decades past.
While that’s undeniably disappointing news for borrowers, they should remember that even with two more hikes, the “market” (or discounted) mortgage rate in Australia will only be 7.6%. In January 1990 it was over 15%.
And although it is cold comfort for those with big loans, higher interest rates will be terrific news for net savers and Australia’s growing class of retirees, who should be heavily invested in cash-like securities. It means that these folks should be able to generate near-risk free cash or “enhanced cash” returns of 7% to 8% per annum. That’s easy, safe money.
On the flip side of the coin, further increases to the RBA’s target cash rate mean that we are likely to see a little more softening in house prices before the central bank starts cutting costs again.
It means that the rental market will continue to tighten beyond its already very firm levels with vacancy rates at all-time lows. Perversely, it means that
And, unfortunately, it means that Australia’s mortgage default rate, which stands at an internationally very low 0.7% today, will probably edge up further.
The good news is that potential buyers and investors are going to be presented with more favourable valuation prospects.
The dynamic whereby disposable household incomes in Australia rise solidly while house prices flat-line or decline modestly, which has held for the last year or so, will be reinforced.
As I have argued countless times before, this is not a bad thing. Asset prices cannot always appreciate. Investment is not a one-way bet. Prices will typically fluctuate through the cycle.
In fact, as I showed recently, one in 10 Australian property investors lose money when they trade their homes, and that is before accounting for transaction costs. On average, they do well: excluding rents, the compound annual capital growth rate over the past 10, 20 and 30 years has been 7 to 8%. Including rents, that number is considerably higher.
When you buy a home, you are, on average, making a seven- to eight-year commitment. So you need to consider what your total post-tax returns will be over this period.
A conservative guide is that asset prices will track disposable incomes through the cycle. Historically, disposable incomes have expanded at a 6% per annum pace in
If you can generate this kind of capital growth (CGT-free if you are an owner-occupier) in concert with net rental yields of 3 to 4% per annum, you are doing fine. Of course, this is an average outcome. Some will do better, others worse. That’s called risk.
As part of a broader portfolio, housing is a good “diversifier” because its returns tend to be uncorrelated with – or move in a different direction to – most other investment classes.
My own reckoning is that patient folks opportunistically investing in housing over the next one to two years are probably going to get the best prices, and valuation fundamentals, that they will have had access to in a long time.
The demand-and-supply fundamentals underpinning Australia’s housing market are already quite attractive. They are only going to get better over the next 12 months. The one fly in the ointment is interest rates. When the RBA comes to cut them, affordability in this country is likely to be the best we have seen in over a decade, which will help to fuel a very strong recovery (and encourage people to allocate scarce capital to improving supply).
In the heated debate about interest rates, people seem to forget that 90% of Australians have variable rate debt. As we saw during the GFC, it is much easier to cut interest rates, and bequeath instant cash-flow relief to all those households paying off loans, than it is to chase the inflation tiger by the tail.
Trust me, you want our RBA to be vigilant in attacking inflation. You don’t want it to get too far “behind the curve”, which yesterday’s data confirms it is.
If the RBA has to respond belatedly to an entrenched inflation problem the likes of which it struggled with in the decades prior to the 1990s, you will be slugged with much more challenging conditions. You will be dealing with the bad old days of double-digit interest rates.
And in the event the RBA does get its monetary policy settings wrong (i.e., overcooks the interest rate egg), it will not hesitate to correct the mistake and grant instant relief to everybody with a loan.
So what actually happened yesterday? As I have predicted for more than a year, Australia officially has an inflation problem.
Underlying or core inflation has been running at more than a 3.5% per annum pace over the last six months. That is one percentage point above the RBA's implied 2.5% per annum target, which just happens to be the highest inflation target in the developed world. (Remember, inflation is a tax on your savings.)
August or September now loom as very likely for the first RBA cash rate increase. And I reckon we will get another one before the year is out, following which the RBA will probably sit on its heels and watch and wait.
What makes yesterday’s inflation numbers so much worse – we already knew that the cost of living indices were running at an annual pace of circa 4% – is that the June quarter was supposed to be a softer outcome, one where we got statistical payback for the incredibly high first-quarter numbers.
All the economists were canvassing downside risks to their projections for core inflation of around 0.7%. And many economists argued that the first quarter numbers had potentially been dragged up by the floods, even though core inflation is meant to strip out the impact of unusually strong price rises.
Recall also that throughout the last six months we have had huge currency appreciation (both in US dollar and trade-weighted terms), which, we were told, should have been deflationary. Indeed, the currency appreciation in the last quarter was much stronger (more than three times as much) as the appreciation in the first quarter.
Finally, we have had non-stop war stories about the “retail recession” and how there is massive, across-the-board retail discounting.
Guess what? They were all wrong.
In the first quarter, average core inflation was 0.85%. In the second quarter, average core inflation was 0.9% (taking the average of the trimmed mean and the weighted median).
And this is before Australia starts digesting an unprecedented increase in private investment via the commodity price boom and urbanisation of Chindia.
It is before Australia starts importing more inflation from China, where wages and prices are sky-rocketing care of a pegged currency and inflationary US monetary policy.
It is with the benefit of a near-100% appreciation in the currency from the 60US¢ lows touched in late 2008 and early 2009.
Glenn Stevens told our parliamentarians at the start of 2011 that the RBA had a history of getting "behind the curve" with respect to inflation, which has averaged an unacceptably high 3% per annum over the last decade.
Stevens told MPs that the RBA had to learn from its mistakes and that if you waited to remove all risk to your forecasts – if you waited to eliminate all uncertainty (as many have argued they should) – it would be too late. The inflation genie would be out of the bottle, so to speak.
Well, underlying inflation in Australia has been running 40% above the RBA's 2.5% per annum target for the last half year. The RBA is now well and truly behind the interest rate curve. It has not touched rates since November 2010, and rate changes today take around another two years to have their full effect.
The inflation doves have been quite sensationally blown out of the sky. Rates are heading higher. Soon.
Christopher Joye is a leading financial economist and works with Rismark International. Rismark and RP Data provide house price analytics products, and solutions that enable investors to go long and/or short the housing market. The above article is not investment advice.