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For most people, the first Tuesday of the month is not an important day.
For anyone who has an interest in economic, finance, property and other related industries, it can be one of the most important days of the month. Some Tuesday’s turn out to be the most important days of the year.
The first Tuesday of June might just be one of those really important Tuesdays – but if you’ve got no clue why, and what it might mean for you, we’re here to break down what the Reserve Bank of Australia’s 50 basis point hike to interest rates means.
The Reserve Bank has an inflation target band of between 2 and 3 per cent. For those who don’t follow the daily and monthly goings-on of the Reserve Bank, this means — let’s be honest — almost nothing. It’s a number. A number that basically tells you a little about how money will move around, what the banks might do, how expensive stuff and things might be (sometimes).
This target rate is, however, crucial to understanding why the central bank is now tightening monetary policy. It’s a “band” in which the bank believes inflation is neither too hot nor too cold and is consistent with price rises in the economy that are essentially benign: they won’t hurt anyone too much, they match with wage growth/cost of living/etc/so forwarth. The ‘Goldilocks Zone’ of inflation rates, if you will.
But inflation has not only moved outside this band – it’s now potentially well beyond it.
“Inflation in Australia has increased significantly,” RBA governor Philip Lowe said, “While inflation is lower than in most other advanced economies, it is higher than earlier expected. Inflation is expected to increase further, but then decline back towards the 2–3 per cent range next year.”
In paraphrased, laymans terms: “Ahem, OK, so inflation seems to be running away a little. Here’s a rate hike to rein things in a bit.” And to be completely honest, this isn’t an odd thing to hear from the RBA – this sort of reaction is pretty much exactly what everyone’s been predicting for weeks now.
It’s all a bit confusing though.
Well, you could easily argue that the price pressures in the economy aren’t connected with the sorts of forces that would be “tamed” with tighter monetary policy. For example, petrol price spikes and higher energy bills are related to the pandemic and geopolitical tensions. There’s not much the Reserve Bank can do about that. If anything, higher mortgage borrowing costs and rents only add to cost-of-living pressures.
But David Bassanese, BetaShares chief economist, reckons the Reserve Bank is looking beyond all of that and sees the potential for inflation (prices) to rise significantly higher than now. Yes, much higher still.
“[The RBA] has clearly heeded the lessons of the US Federal Reserve which arguably waited too long to lift interest rates as US inflation lifted last year — and is now at risk of having to create a US recession to get America’s inflation genie back in the bottle.”
The difference between the United States and here in Australia is that American wages are rising at a very healthy pace. Wage pressure in Australia, at 0.7 per cent over the March quarter, is still relatively subdued.
But with a tighter labour market (ie. low unemployment), and evidence businesses are basically passing on just about all higher costs onto customers, the fear is that a wage price spiral will ensue.
For those not in the know, a wage-price spiral is a macroeconomic theory used to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. The wage-price spiral suggests that rising wages increase disposable income raising the demand for goods and causing prices to rise, as the people with disposable income will want to spend that money in whatever way they see fit. Rising prices increase demand for higher wages, which leads to higher production costs and further upward pressure on prices creating a conceptual spiral.
The reality though is that wage growth caps still exist across the states and territories for public sector employees.
New South Wales has the strongest cap at 3 per cent (announced yesterday). That’s still well below the increase in the cost of living. And the evidence from the latest national accounts shows workers are taking a record low share of national income. The vast bulk of economic growth is being absorbed by firms in the form of profits.
The Reserve Bank sees this improving.
“The Bank’s business liaison program continues to point to a lift in wages growth from the low rates of recent years as firms compete for staff in a tight labour market,” Dr Lowe said
That may go some way to explaining why the stock market reaction to the news of the surprise rate hike was so savage. That is, investors don’t buy the Reserve Bank’s rose-coloured view on wages and fear the economy, and company profits, are about to take a hit.
What about the property market?
Well, again, the Reserve Bank believes households can cope: “The household saving rate also remains higher than it was before the pandemic and many households have built up large financial buffers.”
The share market reaction points to the Reserve Bank’s decision putting a real dampener on growth.
Economists believe if the RBA sees signs unemployment is rising, perhaps with the potential for it to rise back above 4 per cent, it will stop tightening … but who knows?
The risk is that it keeps tightening, the economy stalls, unemployment rises and inflation doesn’t budge. Economists call that stagflation. That’s a real risk because one can argue the economy isn’t in fact particularly strong right now – because a big proportion of economic growth is being generated by consumers dipping into their savings — and the rate hikes won’t materially influence the price pressures in the economy.
The Reserve Bank is looking to shake the economy up, let go of its extreme stimulus and move forward to normalise rates.
There’s a real risk the economy simply isn’t ready for that yet – but Australia has a long history of weathering economic shocks well, so everyone’s hoping we’ll come of this one all right.