The RBA is still expected to raise the cash rate by 25 basis points in May, but historical precedents suggest it may be a little unnerved by the current contraction in new housing finance.

This week's data releases have painted an interesting picture for the near term outlook for monetary policy. We still expect the RBA to raise the cash rate by 25 basis points in May, but there are historical precedents to show that the Bank may be a little unnerved by the current contraction in new housing finance.
On the positive side, consumers continue to show little reaction to interest rate moves. The Westpac-Melbourne Institute Consumer Sentiment Index rose 0.2 per cent to 117.3 in March, a solid positive result. This is despite the Reserve Bank raising the overnight cash rate by 0.25 per cent to 4.0 per cent in March and banks increasing their variable mortgage rates by an equivalent amount, taking them to an average of 6.9 per cent.

The resilience of sentiment is encouraging but we suspect it may not last. History suggests 7 per cent is a significant threshold mortgage rate for consumers. When the RBA raised the cash rate in December 2003 from 5.0 per cent to 5.25 per cent the average variable mortgage rate increased to a comparable 7.05 per cent. The Westpac-Melbourne Institute Consumer Sentiment Index was reasonably stable falling by only 1.9 per cent. When the Bank next increased the cash rate, by 0.25 per cent in March 2005, the variable mortgage rate rose to 7.3 per cent and confidence plummeted by 15.5 per cent. Over the 2006-2008 period the Bank increased the cash rate on seven further occasions in tranches of 0.25 per cent with the variable mortgage rate reaching 9.35 per cent in March 2008. The average fall in the Index following each of those moves was 8.5 per cent.

Based on this evidence alone we may be nearing the point where confidence becomes much more sensitive to increases in interest rates.

Of course, households are holding significantly more debt than during that last period. Debt to income ratios are around 20 per cent higher today than they were in 2003. And that may make them even more sensitive to rises this time around.

The housing sector is the other famously interest-rate-sensitive part of the economy. Recall that following the December 2003 rate hike the Bank stayed on hold for 15 months. A major reason for that extended pause related to the response of new housing finance to the consecutive 25 basis point rate hikes in November and December 2003. Over the six months from October 2003 to April 2004 the number of new housing finance approvals to owner occupiers fell by 17 per cent and remained flat for most of the year, recovering by only 3.5 per cent by year's end.

The recent fall in housing finance as reported by the ABS this week is comparable for owner occupiers. Indeed, the number of owner occupiers receiving new approvals has fallen by 22 per cent – a larger fall than in 2004. However, the numbers are not comparable when we look at the value of finance approvals. In the 2003-04 period the value of new finance approvals fell by 19 per cent whereas in the current period the value of new finance approvals has fallen by "only" 9.5 per cent.

There is a major difference between the current period and 2003-04 when the RBA adopted an extended pause. During that period house prices had increased by 20 per cent; housing credit growth had been growing at a 15-20 per cent annual pace for a number of years; new lending to investors had increased by nearly 40 per cent and investors represented almost 50 per cent of the value of new housing loans. Following the rate hikes in November and December new lending to investors fell at a 35 per cent annualised pace over the next six months.

The effect and primary purpose of the rate hikes (and pointed comments from the Bank at the time aimed at 'jawboning' expectations) had been achieved and the Bank was content to keep rates on hold for an extended period.

Current policy is not aimed at any concerns for housing bubbles. Instead, the current objective of rate hikes is to restore rates to normal levels at a time of limited excess capacity just when the economy is entering an upswing. Moreover, the fall in finance approvals has more to do with fiscal policies than interest rate sensitivity. It is largely explained by the phasing out of the Government's additional First Home Owners Grant with demand from those borrowers now returning to more normal levels. Around 80 per cent of the fall in new lending can be explained by the fall in the new loans to first home buyers.

While the fall in the number of new finance approvals is comparable with the 2003-04 period, the dynamics are entirely different, with the current episode representing the fade out of a temporary Government stimulus plan and the former representing a successful policy initiative to head off a potential property bubble.

The Reserve Bank Governor has commented several times now that he did not see current developments in the residential property market has bearing the hallmarks of a bubble. We concur. House prices have increased mainly due to housing shortages, the accumulated result of years of under-building and a doubling in the pace of population growth (from 1.2 per cent a year mid-decade to 2.1 per cent a year currently). At the margin, the additional First Home Owners grant may also have stoked prices but this is now being withdrawn and we are already seeing prices soften in the lower end of the market.

The real focus for the RBA at present is the labour market. The modest rise in the unemployment rate in this week's report from 5.2 per cent to 5.3 per cent will do little to allay concerns that the unemployment rate is converging rather quickly on the NAIRU – the rate below which pressures start to generate a pick up in inflation, thought to be around 5 per cent. As discussed last week, the market's record in underestimating the strength of the labour market is legendary. Over the last five years there have been only nine (now 10!) occasions when the market has overestimated the employment data by 10,000 or more and 35 when it has underestimated – the usual plus 10-15,000 market forecast next month looks to have substantial upside risks.

Overall we assess this week's data as consistent with a May rate hike, with the new finance numbers indicating the effect of the unwinding of a stimulus package rather than anything more fundamental.

Bill Evans is chief economist at Westpac.

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