Weekend Economist: How high?

With inflation stirring, the debate is beginning to move from whether the RBA will cut or hike next, to how high rates might go.

Over the week markets have significantly reduced probabilities of a rate cut early next year.

Those probabilities have halved from around 72 per cent to 36 per cent. The main driver of this movement has been the inflation report for the June quarter, which showed that underlying inflation printed 0.7 per cent for the June quarter compared to "official" forecasts of 0.6 per cent and what we assess as the market's "whisper" forecast of 0.5 per cent (a lower than expected inflation number in New Zealand, which is typically used by markets as a lead indicator for inflation in Australia was behind the optimistic expectations from the market).

So, consider the last 12 months' underlying inflation profile. September last year printed 0.7 per cent; December (0.8 per cent) and March (0.6 per cent) averaged 0.7 per cent (Reserve Bank of Australia has noted unusually high degree of noise around December/March numbers and recommended an average approach to considering these numbers); and June also printed 0.7 per cent for the quarter and 2.8 per cent for the year, up from 2.4 per cent in the year to June 2013.

With underlying inflation now in the top half of the bank's target band there is limited flexibility to adopt the easing bias which markets had been anticipating unless the bank extrapolates the weak consumer data we have seen since the federal budget and markedly lowers its growth profile for 2015. The bank is set to review its forecasts in the August statement on monetary policy. With this "soft patch" undoubtedly related to a negative response to an unpopular budget the bank is almost certain to take a patient approach to assessing whether current weakness will be sustained.

In that regard, there are a number of developments over recent weeks pointing to the likelihood that conditions are improving: house prices are rising again. After a surprise fall in May, down 1.9 per cent; they recovered in June, up 1.6 per cent; and are likely to be reported to have risen by a further 1.6 per cent in July (to be reported next week); auction clearance rates have started to rise again; high frequency measures of consumer sentiment have recovered; the component in the Westpac Melbourne Institute index of consumer sentiment measuring the outlook for family finances over the next 12 months plunged by 23 per cent, post budget, but has now rebounded by 18 per cent to be "only" 9 per cent below the pre-budget level.

Westpac is maintaining its call that the RBA will be raising rates from the September quarter next year.

In that regard an important issue is how far rates might rise in the next tightening cycle.

The best approach in making that assessment is to forecast the new "neutral" rate. The "neutral" rate is defined as that real rate which keeps GDP growth at its potential with inflation around the RBA's target. Rates above "neutral" will be constraining growth while those below "neutral" will be stimulatory for growth.

The second aspect of the process is to assess how far above "neutral" rates need to move as the tightening cycle intensifies.

Potential growth will be determined by productivity growth and growth in the labour force (essentially population growth in the long run) while preferences for saving will also impact calculations, (sensitivity of investment, including property, to a particular rate of interest is captured by these preferences).

A good example of this thinking is the long run forecasts of the Federal Open Market Committee which sees long run federal funds rate at 3.75 per cent; long run GDP growth at 2.25 per cent and long run inflation at 2 per cent. Therefore the real long run Federal funds rate is estimated at 1.75 per cent, slightly below estimated real potential GDP growth. Arguably this shortfall might be seen as capturing the effect of "savings" preferences.

For Australia it might be helpful to think of the neutral floating mortgage rate. With around 60 per cent of outstanding credit being mortgage related and only around 15 per cent being fixed the floating mortgage rate seems a reasonable proxy for an interest rate which can be seen to impact activity.

In the 10 years preceding the GFC period the floating mortgage rate averaged around 6.6 per cent. However, this period was associated with the household debt to disposable income ratio lifting from around 70 per cent to 150 per cent. Reasonably, sensitivity to debt and therefore housing investment should have been rising during that period but this was not evident in borrowing and activity levels until the advent of the GFC and households, fearful of house prices and job prospects, sharply lifted savings rates from around zero to 10 per cent of disposable income.

Although gross household debt to disposable income ratios have remained steady at around 150 per cent households have been using these higher savings to strengthen their balance sheets and lower their vulnerability to higher rates. We estimate that household debt net of deposits has fallen from 90 per cent of disposable income to 65 per cent. In addition, households are paying down debt more rapidly. In its latest results Westpac reported that nearly 75 per cent of borrowers were ahead on their scheduled loan repayments.

Since the GFC, and during this period of strengthening household balance sheets, the variable mortgage rate has averaged around 6.1 per cent. Reasonably, this ongoing strengthening of balance sheets should raise households' investment preferences. Of course, at this stage of the cycle risk aversion still dominates but this evidence points to a lower sensitivity to rates at whatever time the economy moves back near equilibrium (economy growing at potential and inflation around target).

Choosing a future "neutral" rate will always be subject to considerable uncertainty but a 6.5 per cent target for the floating mortgage rate seems reasonable for the next cycle given strengthening household balance sheets over the last 7 years.

What does this mean for the RBA cash rate?

The current spread between the cash rate and the variable mortgage rate is 260bps. That is up from a 130bps average pre- GFC. Based on the previous discussion the "neutral" cash rate would be 4 per cent, assuming that the mortgage /cash rate spread holds.

In assessing that likely spread two arguments are relevant. Firstly, spreads are even narrower in other OECD countries. Secondly, the increase in spreads post GFC was associated with banks' moving to rebalance funding ratios towards a higher proportion of retail funding. The resulting pressure on deposit rates contributed to widening mortgage spreads. With funding ratios now rebalanced, competition for assets amongst banks might see those asset spreads narrowing through the next tightening cycle. That would put upward pressure on the neutral cash rate for a given neutral floating mortgage rate.

For now, our forecast of the neutral cash rate during the next tightening cycle is retained as 4 per cent with potential for that rate to increase under the pressure of banks' competition for assets.

Finally, we need to assess the likely overshoot of the cash rate above the neutral level. Our forecasts include a 75 basis points overshoot. With balance sheet repair in the household sector raising preferences for debt in the next cycle that estimate might prove to be conservative.

Westpac is expecting the next tightening cycle to begin in the second half of 2015. Markets are likely to begin to anticipate that cycle around 6 months in advance. While markets are currently in denial that a business cycle exists, current market estimates of the peak rate in the cycle look to be conservative.

With the neutral cash rate around 4 per cent we expect the next market peak in the cash rate to be 4.75 per cent - fixed rates are likely to eventually embrace that outlook.

Bill Evans is chief economist with Westpac.

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