Speaking at the KangaNews Debt Capital Market Summit on Monday, RBA assistant governor (financial markets) Christopher Kent said that it takes time for the effects of increased interest rates to filter through to the broader economy.
The target inflation rate was established by then-RBA governor Bernie Fraser in March 1993, during a speech to economists, in which he said: “The appropriate degree of price stability to aim for is a matter of judgment”.
“My own view is that if the rate of inflation in underlying terms could be held to an average of 2 to 3 per cent over a period of years, that would be a good outcome.”
This sentiment has guided RBA policy for the past 30 years and is the driving force behind the current period of quantitative tightening.
Commenting on the bank’s decisions of late, Mr Kent said: “Currently, the bank is focused on bringing inflation back down to the target range. High inflation imposes a significant burden on the finances of all Australians”.
“The rise in interest rates, which is needed to rein in inflation, imposes an extra burden on mortgage holders, but that burden will be higher still if we don’t bring inflation down in a timely manner.”
However, the assistant governor emphasised that the tightening of monetary policy isn’t a magic switch that can be flipped to immediately induce changes in business and household spending.
“Monetary policy affects the spending and investment of businesses and households with a lag. In turn, those changes in demand take time to have their full effect on the setting of prices and wages,” Mr Kent explained.
Due to the lag, central banks face a number of challenges in “setting monetary policy with a view to the future”, as noted by him.
“The lags in the transmission of policy are not only long, but they are variable, changing over time in response to cyclical and structural changes in the economy. Further complicating matters, the lags are different across the different channels of monetary policy.”
Drivers of the lag
Mr Kent explained that the high percentage of fixed-rate mortgages, which reached a peak of just above 35 per cent of all mortgages in early 2022, compared with the pre-pandemic average of approximately 20 per cent, is one of the main reasons for the delay in the flow-through of tightening.
“The unusually high share of fixed-rate loans when the bank started to tighten monetary policy has added an extra delay to the pass-through to outstanding mortgage rates,” he said.
“Since last May, the average outstanding mortgage rate across all loans has increased by around 110 basis points less than the cash rate. More than half of this difference owes to the effect of fixed-rate mortgages that haven’t yet rolled onto higher interest rates.
“Also, the average outstanding rate for variable-rate mortgages has risen by around 40 basis points less than the cash rate as a result of competition among lenders for good-quality borrowers.”
He noted that if fixed-rate borrowers had been adjusting their spending in anticipation of rolling over to a higher rate mortgage to better manage their spending, the proportion of fixed-rate borrowers would not have had such an impact.
“I suspect many fixed-rate borrowers do not adjust their spending in advance, but rather wait until they roll onto the higher rate,” Mr Kent added.
“Even those that are more forward-looking are likely to make moderate adjustments at first, with further adjustments required at the time of the switch. Hence, despite the potential for some forward-looking behaviour, it is plausible that the high share of fixed-rate loans has contributed to a longer lag for the cash flow channel.”
The assistant governor also cited the savings buffers accumulated by mortgage holders during the pandemic, with a significant portion of it stored in offset and redraw accounts, as another contributing factor to the delay.
Whether households will tap into these savings or not, he said, would play a crucial role in determining the trajectory of the economy going forward.
“If borrowers allow these additional savings to run down even to some extent, it will help to sustain their current spending in an environment of higher interest rates and cost-of-living pressures,” he said.
“That is, they can choose to delay some or all of the effect of the cash flow channel of monetary policy on their spending for a time. Whether they will do this, however, is uncertain.”
While Mr Kent explained that the high proportion of fixed-rate loans and sizeable buffers held by many borrowers means that it’s likely to take longer than usual to see the full effect of higher interest rates on household cash flows and spending, he added that other channels of monetary policy should remain effective.
Ultimately, Mr Kent assessed that the rise in interest rates in Australia has helped to support the value of the Australian dollar, which in turn has helped suppress the prices of imported goods and services.
“In short, all of these other channels of monetary policy are helping to slow the growth of aggregate demand and bring down inflation,” he concluded.
