Econosights: How are consumers responding to higher interest rates?

Introduction

The Reserve Bank of Australia (RBA) has begun the process of lifting interest rates. So far, the cash rate has gone up by 75 basis points from 0.1% in April to its current level of 0.85%. While the increase in interest rates has been small so far, there is already evidence that rising interest rates are having a negative impact on consumers. The purpose of lifting interest rates is to slow consumer demand to bring down the high pace of inflation, so the RBA would be pleased that its changes to monetary policy are having the desired impact, although the central bank still has to tread carefully not to crush the consumer if it wants to avoid a serious growth downturn. In this Econosights we look at the implications to households in Australia from rising interest rates.

Interest rates

Consumers feel the impacts from changes to the RBA cash rate mainly through adjustments to mortgage rates, with around 37% of households having a mortgage, and this doesn’t account for those with an investment property so the actual share would be higher. In Australia, mortgage rates are either fixed or variable. Historically, most home loans (~75%) have been on variable rates which has been effective in the last 12 years as the cash rate has been coming down. In the last 2-3 years, a record low cash rate, expectations of low interest rates and high competition between lenders had been forcing down mortgage rates, especially for fixed loans with around 50% of new lending being fixed. But, from mid-2021, a re-pricing of RBA rate hike expectations because of the removal of the 0.1% bond yield target and a quick lift in inflation has caused a lift in fixed rates with the average 3-year owner-occupied rate more than doubling from 2.1% in March 2021 to 4.7% in May 2022. Variable interest rates have moved in line with changes in the cash rate so far (see the chart below).

The rising cost of debt will put downward pressure on consumer spending. The share of housing interest payments relative to income were close to a record low at 4.4% in March 2022 and we expect an increase to ~7% with the cash rate at 2.1% and to ~7.5% with the cash rate at 2.6% (our view of the “terminal” rate) which would take debt servicing costs to its highest level since 2013 – see chart below.

Consumer spending is slowing

The signs that interest rate hikes are working to reduce consumer demand include:

• A slowing in the housing market. National average home prices are down by 1.2% since the first interest rate increase. Prices were already slowing before the RBA started lifting interest rates which is different to the usual start of a rate hiking cycle where prices tend to be rising, with falls only starting after a few rate hikes. Auction clearance rates have dropped to just over 50% in Sydney and Melbourne after ~70% earlier this year, new housing lending is declining (and already was before the RBA lifted rates) and more falls are expected as mortgage rates rise and building approvals have fallen back to pre-Covid levels (after a big boom in 2020/21 from the governments HomeBuilder subsidy). This all points to more downside for home prices and we see national average home prices falling by 10-15% top to bottom into 2023. A decline in home prices is negative for consumer wealth (housing makes up 65% of total wealth) and as a result, consumer spending because of the impact from the “wealth effect” (an increase (decrease) in wealth lifts (lowers) consumption) – see the chart below.

• A fall in consumer sentiment. The Westpac/Melbourne Institute consumer confidence index is at its lowest levels since the GFC (not including the initial Covid fall) and the weekly ANZ/Roy Morgan confidence index is around its lowest levels since the series began in 2010 (also excluding the initial Covid plunge). Confidence is weaker than it usually tends to be at the start of past RBA rate hike cycles. Weaker confidence would also reflect the high inflation environment (especially on essentials) which is outpacing growth in wages (on average).
• A slowing in retail spending. Weekly credit card spending data from the major banks is stalling in June after months of high growth and bank surveys of consumers indicate a pull back in spending especially on services. The high inflation environment would also be working to reduce retail spending.

There are still some positives

While there are a lot of headwinds for consumers at the moment, there still remain some positives:

• Households are sitting on a large pile of accumulated savings worth around ~$250bn (see the chart below) or 11% of GDP which will act as a buffer against higher interest rates and inflation. The accumulation in savings reflects the high savings rate over 2020/21 (the savings rate averaged ~16% over the last 2 years, compared to 6.5% before Covid) from government distributions to households, interest rate cuts and forced savings as services activity was closed off. Households are expected to drawdown on these savings over coming months.

• Lending fundamentals look sound. RBA research shows that ¾ of variable mortgages are more than 3 months ahead on repayments which provides some support as interest rates rise. APRA data on “risky” mortgage lending shows some a rise in lendiing for high debt to income ratio loans (of 6x) lifting from 15% of new loans in March 2019 to 23% of new loans in March 2022 but this is not alarmingly high. The share of new lending to loans with high loan-to-value ratios (over 90+) remains low at 6% of new loans, around its lows for recent years.
• Wages growth is rising with business surveys showing more upside to labour costs and the recent minimum wage decision awarding a 5.2% increase to the minimum wages and a 4.6% increase to award minimum wages which impacts around 20% of employment and could be a catalyst for others seeking pay rises.
• Inflation should moderate in 2023 if commodity prices decline from recent highs (with positive signs of this recently) as effects from the domestic floods pass through and electricity prices normalise.

Conclusion

We expect consumer spending growth to slow in 2022/23 in response to higher interest rates and inflation. This should help to reduce the pace of inflation. While there should be enough positives to avoid a serious downturn in consumer spending, household consumption is still expected to slow over 2022/23, particularly on discretionary items.

We expect that the RBA will need to hike the cash rate to around 2.6% to get inflation back down towards or in the 2-3% inflation target band. If the cash rate goes above 3%, we see more serious downside for consumers because of the impact on debt servicing costs for mortgages.

Financial markets are expecting the cash rate to reach close to 4% in mid-2023 which we think looks overdone because of its significant negative impact to consumers.

Diana Mousina
Economist – Investment Strategy & Dynamic Markets
(AMP Capital)