A cautious approach to interest rate hikes

The Reserve Bank decides on Wednesday (13 April) what it wants to do to interest rates. This means that economists are beginning to dust their crystal balls, brush off the tarot cards, and meet up to argue over craft beers in back alleys as to what the Bank will do.

Not to be left out, I had better get on the bandwagon.

A few weeks back, economists were almost unanimously saying the Reserve Bank would hike the Official Cash Rate (OCR) by 50 basis points (0.5%), while most are now saying that a 25 basis point hike (0.25%) is all that is needed.

The direction of travel for interest rates is easy from the Bank’s perspective.

Essentially businesses and households are beginning to act like inflation will accelerate and persist for longer. We might even see 10%pa plus inflation appearing in upcoming data. Inflationary expectations have become unhinged, and the Bank needs to stamp that out otherwise this will all become a self-fulfilling inflationary prophecy. The Bank needs to say it will not tolerate inflation over the medium-term, so you all had better pull your heads into line and not get cheeky with how you are pricing your goods, services, and salary expectations.

So an increase to interest rates in some shape or form is easy enough to predict. However, the magnitude of how much the Bank should increase rates is a little trickier.

Economic conditions have deteriorated over recent weeks as war rages in the Ukraine and the pandemic goes on, and the confidence of businesses and households has taken a hammering.

This situation will be causing a few restless nights at the Bank – it puts them between a rock and a hard place. The last thing it wants to do is raise interest rates by too much and cause the economy to tank.

This means that the Bank is likely to have become a little more cautious in how much it is willing to hike interest rates. It will now be thinking that the strategy of least regret is to lift rates by a slither and accompany that by a strongly worded statement that it won’t hesitate to act further at future official cash rate reviews. This points towards a 25 basis point increase this meeting, with the possibility of further and even larger hikes at upcoming meetings if economic conditions allow.

Some economists have previously argued that these types of actions are “bird brained”. I won’t go there as throwing barbs at someone’s intellect is not necessary.

What I will add though, which will be in the forefront of the Bank’s mind, is that private markets have already done some of the heavy lifting on interest rates. For example, one-year fixed mortgage rates have doubled from 2%pa to 4%pa since mid last year. As households refix their mortgages these increases are already beginning to take some of the heat out of the spending frenzy that persisted last year. To put things in perspective, a household refixing a $500,000 mortgage is going to need to find another $200 per week in their budget to pay for the lift in their mortgage rate. Finding this money will cause material shifts in household spending patterns and will help rein in some pricing pressures.

Anyway enough from me, I should turn back to arguing over craft beers while I await next week’s review of interest rates by the Reserve Bank.