Interest rates and inflation: where are they heading?

By November 2, 2021 November 16th, 2021 Property Investing
Inflation and interest rates

The topic of rising inflation and its potential impact on interest rates has been dominating the financial press over the past few weeks. The bond markets expect that higher inflation readings will force central banks to raise interest rates.

It’s my opinion that higher inflation is likely to be temporary. And it’s also useful to remember that “markets” (and popular opinion) are not always right. Bond markets priced-in higher inflation in February 2021 but eventually normalised after a few months.

A quick economics lesson: why does inflation lead to higher interest rates?

Inflation is a measure of rising costs. Inflation is measured by the ABS using a basket of goods and services. High inflation is bad for an economy because it erodes purchasing power, increases uncertainty and can have a negative impact on the value of a country’s currency.

A key role of the RBA is to manage inflation so that it remains inside its targeted 2% to 3% band. It does that by changing the cash interest rate (currently 0.10%). Increasing interest rates, reduces spending (because the business and private sector must direct more money towards interest costs) and therefore reduces demand for goods and services which cools price increases.

Therefore, if markets expect that high inflation will persist, they price in that interest rates will increase, which negatively impacts the value of existing bonds, particularly if the coupon (interest rate) is fixed. This has been happening since August 2021 i.e. bond values have been falling.

What’s causing higher inflation?

As announced by the ABS last week, Australia’s inflation is 3% for the year ended September 2021, which is at the top end of the RBA’s target band. It was slightly less than expected (3.1%) and lower than last quarters annualised reading of 3.8%.

This time last year, inflation was less than 1%, so what has happened since then? The chart below sets out how prices have changed over the past year. Five categories have risen by more than 2% over the past year being transport, furnishings, health, alcohol and tobacco and recreation.

Inflation
  1. Transport – driven mainly by the rebound in the oil price. This time last year, oil was trading at around $40 per barrel, mainly because most of the world was in lockdown. Oil has since recovered and is currently trading at over $80 per barrel, which is closer to the long-term average price. Its unlikely the oil price will continue to rise, certainly not at the same pace.
  2. Furnishings – the cost of furnishings have been driven by unusually high demand and supply shortages (supply chain disruptions).
  3. Alcohol and tobacco – the main contributor were tobacco prices due to increase in government excise and customs duty in 2020.
  4. Health – these price rises have been mainly driven by health insurance premiums.
  5. Recreation and culture – price increases were mainly driven by domestic holiday travel and accommodation due to the closure of international borders.

It is likely that inflation is transitory

From a review of the above, it becomes clear that inflation has been driven by some unique events which are unlikely to persist. The only exception may be health insurance premiums, which seem to increase each year.

The Covid pandemic has caused several issues:

  • Supply chain disruption: The China Containerised Freight Index demonstrates how the cost of shipping has risen throughout the pandemic. This has been caused by a number of things including higher demand for durable goods, stevedoring strikes, container shortages and trucking shortages.
  • Unusual demand for durable goods: Australians have spent a lot of money on durable goods throughout lockdown including second-hand cars, furniture, household goods and so forth. Spending is not only likely to normalise once life returns to pre-Covid normal, but it’s entirely likely that demand for these goods will be below normal levels for a few years.
  • Savings: One of the consequences of being in lockdown is that Australians have been spending less and saving more. Bank deposits have increased by over $140 billion since March 2020, which is more than double the normal rate. The redeployment of these savings into the Australian economy could temporarily fuel inflation over the next 1 to 2 years.

It is rare to have persistently higher inflation without income growth

Generally, higher inflation requires higher incomes, because how can you afford to pay more for goods if you are not earning more income? This is the main reason I think inflation in transitory, not permanent.

The RBA’s wage growth index is well below 2% p.a. Therefore, how can the prices of goods continue to rise if Australians do not have more money to pay for them? At some point, spending and supply chains will normalise, and inflation will subside.

Prediction that higher rates will lead to falling house prices

I was most surprised to read in the Australian Financial Review a prediction by bond trader, Chris Joye that forecasted a 1% increase in interest rates could lead to a 15% to 25% fall in property prices (and more recently here).

I have followed Chris for many years and have found his commentary always insightful and forecasts mostly accurate. However, on this occasion, I couldn’t be less agreeable. Coincidentally, I did write in this blog last week that each year, a high-profile commentator predicts a property market crash, so maybe it’s Chris’ turn.

The chart below illustrates household debts and related interest costs. The dotted lines represent the interest cost after a 1% and 2% interest rate rise. It is evidence that a 1% rise is quite affordable. However, it is conceivable that a 2% rise will probably put pressure on household budgets.

Therefore, if mortgages are still affordable after a 1% interest rate hike, why would property prices fall?

We shouldn’t forget that lenders test borrowers’ affordability at circa 5.5% p.a. when you apply for a loan.

In addition, most property buyers throughout the pandemic have been owner-occupiers, not investors. Owner-occupiers typically will not sell their homes unless it is their last resort. If interest rates rise, they will reduce discretionary expenditure first before they even contemplate selling their home.

Finally, anyone that has applied for a loan over the last 5 years knows that it’s a very thorough (understatement) process. That is, banks do not lend money to a borrower if they believe that a 1% rate hike would lead them to experience financial stress.

1% rate rise

Property prices are not unsustainably high

It’s been well documents that property prices have increased a lot of the past 12 months. However, we must put recent rises into perspective. Over the past 5 years, the median house price in Melbourne has increased by 6.9% p.a., Sydney by 6.6% p.a. and Brisbane by 4.7% p.a. These growth rates are all below the long-term average.

And growth rates over the past 10 years have also been below the long-term average. What has occurred over the past year is simply mean reversion.

Therefore, whilst recent property price appreciation appears unsustainable over the past year (and it is), in longer term context, it’s not alarming or unusual.

What will happen to interest rates?

Raising interest rates probably will not cool inflation since factors other than consumer demand have caused it. However, it’s true that interest rates cannot remain at currently expansionary settings forever.

The million-dollar question is what the neutral interest rate is i.e. a level where interest rates are neither expansionary nor contractionary. I suspect that level is in the range of 4% and 5% p.a., particularly as household debt has risen. The RBA should return the interest rate settings to neutral as soon as its confident the economy has recovered from the impact of the pandemic.

In terms of the timing and speed of rate increases, there are also two important observations. Firstly, given the rise in federal and state government debt, any increase in interest rates will have a big impact on government budgets (deficits). As such, I’m sure politicians will be keen to keep a lid on rates for as long as possible.

Secondly, it’s been well documented that lower income earners have been adversely impacted by Covid, whereas most higher income earners have not experienced any negative financial implications. Therefore, raising rates will adversely affect the people that can least afford it i.e. lower income earners.

I suspect that interest rates will not begin to rise before late 2023. And I suspect that when interest rates do rise that they will do so slowly. That said, it is wise to use low-interest rate periods to reduce debt (i.e. accumulating cash in offset), because low rates won’t last forever.