Why the RBA lifted rates

PORTFOLIO POINT: Australia has been the odd man out in this cycle, and this week’s rise may not mean imminent rises elsewhere.

Don't take the Reserve Bank's rate hike as a warning of imminent tightening elsewhere. Macro-economically, Australia is been the odd man out in this cycle and it’s worth examining why.

However, concerns about rising house prices seemed to contribute to the decision. That may hint at change in central banks' attitudes to asset prices.

The RBA lifted its cash rate target to 3.25% from 3% earlier this week, the first G20 central bank to tighten policy. Don't take this as a leading indicator for other economies. The bank tightened rates because Australia has avoided a technical recession (GDP fell in only one quarter).

Here's what made Australia different:

First, most household debt is mortgage debt, and about 90% of mortgages are floating-rate. That means that changes in the cash rate target flow through to borrowers almost immediately with a typical lag of one week.

The chart below shows the cash rate target and the average interest rate paid on the stock of household debt.

Second, this quick pass-through meant that Australia benefited from being a high-debt economy. Australian consumers are more indebted than their US or UK counterparts. Debt is 177% of disposable income in Australia, versus 129% in the US.

Because debt is higher, cutting rates has a bigger impact on disposable income. The fall in rates reduced debt service costs from 15.4% of disposable income in June quarter 2008 to 10.3% by June quarter 2009. That is, the saving was worth over five percentage points of household income.

Third, the federal government’s fiscal stimulus was aggressive and focused on supporting household income. The IMF estimates that Australia's discretionary fiscal stimulus in 2009 will be the largest in the OECD (see below).

The combination of lower interest payments, relatively stable employment and fiscal stimulus meant household disposable income increased by 9% over the past year.

If that's recession, bring it on!

Consumers in other developed economies have had to choose between increased saving or increased spending over the past year. Australian consumers could do both. The chart below compares retail sales growth in Australia and the US.

The fourth – critical – difference is that mortgages in Australia are full-recourse. That, in turn, means that borrowers typically default only if they lose their jobs. They don't mail the keys to the bank and just walk away, even if they have negative equity in their properties. With demand growth strong enough to prevent material job losses, non-performing loan numbers remained very low.

All this meant that Australia avoided the debilitating feedback loop – from demand weakness, to job losses, to falling house prices, to credit losses, exacerbating the demand weakness – that deepened the downturn in other economies. (Full disclosure: That Australia avoided this outcome surprised us.)

One final difference: Because the downturn was relatively shallow, the impact on inflation was relatively modest. Core inflation remains near 4%, and the RBA expects that inflation next year will be within, not below, its 2–3% target band. In other words, the RBA had less margin for error on inflation than other central banks.

These macro-economic differences explain the RBA's early move. There are, however, two points to take from the RBA decision when considering events elsewhere:

First, the role of asset prices. RBA rhetoric has flagged concerns about the renewed strength in house prices, although that was not the principal reason for tightening. The ratio of average house prices to average income in Australia is now just under 5:1, compared with about 3.5:1 at the top of the US housing cycle.

As my colleague Joachim Fels has argued, fast-rising asset prices may encourage central banks to tighten sooner than the usual macro indicators would suggest is required. This, rightly, is a new era for policy-makers, where they will aim to lean against incipient asset bubbles.

Second, market reaction to tightening. Risk markets reacted positively to the RBA decision, confirming that an initial policy tightening will not derail the equity rally.

In fact, investors seemed to take the rate increase as a vote of confidence in the growth outlook. Our team does not expect that central banks in the major developed economies will follow in the RBA's footsteps until well into 2010.

The evidence from Australia suggests that the first tightening will not end the rally.

Gerard Minack is head of global developed market strategy at Morgan Stanley Australia.