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Tuesday, April 27, 2010

Where to for rates?

What lies ahead for housing and monetary policy? First, we have the March quarter house price index results from RP Data-Rismark, APM and the ABS due in the next few days. We already know the January and February RP Data-Rismark numbers, which were very strong at more than 1% per month. On the balance of probabilities, the overall March outcome will therefore be on the high side. It is possible that APM and the ABS’s median price estimates give contrasting results due to compositional biases, but all three measures generally move in the same direction.

To date, we have yet to observe the much-anticipated ‘cooling’ in capital growth rates as the cost of mortgage finance starts to normalise. Following the April hike, the headline variable mortgage rate is 7.15%, which is still a few rungs below the long-term rate since the start of 1994 of 7.6%. It is also significantly less than the 8.2% average rate experienced in 2007 when house prices rose by more than 12%, or the recent peak mortgage rate of 9.6% in August 2008.

We know that credit growth has been modest thus far and well down on its double-digit rates over the last 10 years. But the ‘partials’ on housing finance for March and April do not look disturbingly weak (or strong, for that matter).

So, as I have noted before, the RBA has yet to see the twin peaks of home value and mortgage debt growth that would give it some ‘system stability’ pause.

On the other hand, there is evidence of ‘persistence’ or ‘serial dependencies’ in house price movements. That is, past house price growth can be informative of future growth.

The RBA’s concern will therefore be that the current growth rates give rise to future gains, which inevitably feed back into credit growth. And it may not be this year, but in 2011-12.

So there are presumably those internally who would argue that given the unusually firm housing fundamentals—ie, elevated population growth combined with record housing shortages—there is a case for quickly setting rates on the higher side of neutral, if only to err on the side of caution.

The last thing the RBA wants to be accused of is leaving rates at generous levels for too long after its recent housing rhetoric.

The other swing factor is the RBA’s clear view that we must shift our thinking towards ‘managing the upswing’.

Glenn Stevens noted in a speech last week that Australia’s terms of trade have hit 50 year highs for the second time in three years. He pointed out that this may be indicative of a more permanent change.

As the RBA and others have warned, we are also commencing this upturn with much more limited productive capacity (ie, slack in the economy). Analysis by NAB’s Rob Henderson has shown that when Australia’s unemployment rate falls below 5% (it currently stands at 5.3%) we tend to see higher inflation. This is where the so-called inflation-unemployment trade-off really kicks in.

Prior to the GFC there was a 1.8% spread between the RBA’s target cash rate and the headline mortgage rate. Today that spread is 2.9% (or 1.1% higher). And residential mortgages represent around 60% of all credit in the economy.

Using this very simple analysis (which ignores business lending spreads), if the RBA wanted to put the cash rate back to equivalent August 2007 levels (ie, when its target was 6.5%), it would need to increase the cash rate from 4.25% today to about 5.4%.

Another germane example is 2006. In May 2006 the unemployment rate was a little lower than today at 4.8%. The target cash rate at that time was 5.75%. In post-GFC variable mortgage terms, that would be 4.65%. But the difference is that back then the RBA’s preferred measures of inflation, such as the ‘trimmed mean’ indicator, were well below the 3% target whereas the December 2009 print of these numbers was above target. Hence the focus on the inflation numbers tomorrow.

My final word of caution is this. The last time the RBA got really worried about a sustained terms of trade boom combined with very low unemployment (ie, in August 2008), it pushed the cash rate to 7.25% notwithstanding the GFC headwinds at that time. And there were those who were forecasting even higher cash rates by the end of 2008 on the assumption that the GFC turbulence would dissipate. The point being that absent the GFC 7.25% may not have been our peak rate. In post-GFC spread terms, this represents a circa 6.15% cash rate today, which is way above the 4.25% level that we are currently experiencing. All told, the balance of risks look like they may rest on the high-side.