The RBA will hike sooner than you think: Here's why
The last time the Reserve Bank of Australia increased official interest rates was way back in November 2010.
This means that anyone who has taken out a mortgage over the past decade has never been confronted with an email or letter from the bank telling them that their monthly repayments will be increased.
It has been a fabulous time to have a mortgage, made even better by the fact that over that time house price growth has been strong and household incomes have lifted by around 30 per cent.
At worst for the mortgage holder, the monthly repayments have been stable as the RBA held official rates steady for the bulk of the time; at best, the monthly repayment requirement was reduced each time the RBA cut official rates.
Over the decade, the variable mortgage interest rate has fallen by approximately 4 percentage points, from above 7 per cent to now below 3 per cent.
The extended period of low and falling interest rates has been inexorably linked to inflation being weak and below target for many years.
For the moment, inflation is still well below the RBA’s target which is why any near term change in interest rates is unlikely.
What will cause the RBA to hike?
The momentum of the economy is strong. Business conditions have never been higher while consumer sentiment is buoyant. The improvement in the labour market and international border closures, which means no work visa are possible in many industries, is sparking a shortage of workers.
That shortage of workers is feeding clear upward pressures in wages in the private sector. Firms in many industries are having to increase pay offerings to entice workers to work for them and existing staff are receiving pay rises to stop them defecting to a competitor.
These wage pressures are set to show up in the official data within the next year. The exact timing and extent of the acceleration in wages growth is, at the moment, open to debate and analysis, but it would be no surprise to see annual growth in private sector wages exceeding 3 per cent by the middle of 2022 and for upward momentum to continue thereafter.
The good news about this is that this will boost household incomes and support spending.
The other favourable aspect with this is that firms, who are benefitting from a strong economy, are going to be able to pass on their higher wages bill through to their selling prices.
This, by definition, is the pick-up in inflation.
Indeed, it is likely that during 2022, underlying inflation will hit or exceed the mid-point of the RBA’s target. When this happens, it will be clear that a 0.1 per cent official cash rate will be inconsistent with these fundamentals on inflation and wages.
While the RBA has signalled that it needs to see a sustained lift in inflation before it will consider any policy tightening, it reckons that this is at least three years away. 2024 at the earliest is the timeframe the RBA is flagging.
But such are the wage and inflation pressures building now that it may have to revise this timetable to sooner rather than later.
Not just Australia
This rising inflation pressure and ‘early’ tightening in monetary policy is not just a matter for Australia. Central bankers in the Canada, the UK, the US and New Zealand have openly spoken of the possibility of starting a monetary policy tightening cycle as economic recovery takes hold and inflation pressures build.
The boom in commodity prices is an indicator that broad inflation pressure are lifting.
What they are experiencing is much the same the scenario unfolding in Australia.
How painful would a series of interest rate hikes be?
A 2 percentage point lift in mortgage interest rates on a $500,000 mortgage adds $540 to monthly repayments.
That is $540 a month that will need to be allocated to servicing a mortgage and not available to spent in the economy.
Of course, this will be the desired effect – monetary policy will only be tightened in this way as a means to cool economic activity and keep inflation within the RBA target.
The start of the monetary policy tightening cycle is not imminent. Maybe around the middle to latter part of 2022, the RBA will have the information it needs to lift the cash rate from the record low 0.1 per cent.
And when it comes, it should not come as a shock to anyone. After all, the 0.1 per cent cash rate was never going to last forever.
The growing issue now is when the tightening cycle will start and then, how many rate hikes will be needed as the RBA manages its inflation target.
Follow Yahoo Finance on Facebook, LinkedIn, Instagram and Twitter, and subscribe to the free Fully Briefed daily newsletter.