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RBA data still points to May home loan rate hike

This week's data releases have painted an interesting picture for the near term outlook for monetary policy. We still expect the RBA to raise the cash rate by 25bp's in May but there are historical precedents to show that the Bank may be a little unnerved by the current contraction in new housing finance.
On the positive side, consumers continue to show little reaction to interest rate moves. The Westpac-Melbourne Institute Consumer Sentiment Index rose 0.2% to 117.3 in March, a solid positive result. This is despite the Reserve Bank raising the overnight cash rate by 0.25% to 4.0% in March and banks increasing their variable mortgage rates by an equivalent amount, taking them to an average of 6.9%.
The resilience of sentiment is encouraging but we suspect it may not last. History suggests 7% is a significant threshold mortgage rate for consumers. When the RBA raised the cash rate in December 2003 from 5.0% to 5.25% the average variable mortgage rate increased to a comparable 7.05%. The Westpac-Melbourne Institute Consumer Sentiment Index was reasonably stable falling by only 1.9%. When the Bank next increased the cash rate, by 0.25% in March 2005, the variable mortgage rate rose to 7.3% and confidence plummeted by 15.5%. Over the 2006–2008 period the Bank increased the cash rate on seven further occasions in tranches of 0.25% with the variable mortgage rate reaching 9.35% in March 2008. The average fall in the Index following each of those moves was 8.5%.
Based on this evidence alone we may be nearing the point where confidence becomes much more sensitive to increases in interest rates.
Of course households are holding significantly more debt than during that last period. Debt to income ratios are around 20% higher today than they were in 2003. And that may make them even more sensitive to rises this time around.
Housing sector is the other famously interest-rate-sensitive part of the economy. Recall that following the December 2003 rate hike the Bank stayed on hold for 15 months. A major reason for that extended pause related to the response of new housing finance to the consecutive 25bp rate hikes in November and December 2003. Over the six months from October 2003 to April 2004 the number of new housing finance approvals to owner occupiers fell by 17% and remained flat for most of the year, recovering by only 3.5% by year's end.
The recent fall in housing finance as reported by the ABS this week is comparable for owner occupiers. Indeed, the number of owner occupiers receiving new approvals has fallen by 22% – a larger fall than in 2004. However the numbers are not comparable when we look at the value of finance approvals. In the 2003/04 period the value of new finance approvals fell by 19% whereas in the current period the value of new finance approvals has fallen by “only” 9.5%.
There is a major difference between the current period and 2003/04 when the RBA adopted an extended pause. During that period house prices had increased by 20%; housing credit growth had been growing at a 15–20% annual pace for a number of years; new lending to investors had increased by nearly 40% and investors represented almost 50% of the value of new housing loans. Following the rate hikes in November and December new lending to investors fell at a 35% annualised pace over the next six months.
The effect and primary purpose of the rate hikes (and pointed comments from the Bank at the time aimed at ‘jawboning' expectations) had been achieved and the Bank was content to keep rates on hold for an extended period.
Current policy is not aimed at any concerns for housing bubbles. Instead, the current objective of rate hikes is to restore rates to normal levels at a time of limited excess capacity just when the economy is entering an upswing. Moreover, the fall in finance approvals has more to do with fiscal policies than interest rate sensitivity. It is largely explained by the phasing out of the Government's Additional First Home Owners Grant with demand from those borrowers now returning to more normal levels. Around 80% of the fall in new lending can be explained by the fall in the new loans to first home buyers.
While the fall in the number of new finance approvals is comparable with the 2003/04 period the dynamics are entirely different with the current episode representing the fade out of a temporary Government stimulus plan and the former representing a successful policy initiative to head off a potential property bubble.
The Reserve Bank Governor has commented several times now that he did not see current developments in the residential property market has bearing the hallmarks of a bubble. We concur. House prices have increased mainly due to housing shortages, the accumulated result of years of under-building and a doubling in the pace of population growth (from 1.2%yr mid decade to 2.1%yr currently). At the margin, the Additional First Home Owners grant may also have stoked prices but this is now being withdrawn and we are already seeing prices soften in the lower end of the market.
The real focus for the RBA at present is the labour market. The modest rise in the unemployment rate in this week's report from 5.2% to 5.3% will do little to allay concerns that the unemployment rate is converging rather quickly on the NAIRU – the rate below which pressures start to generate a pick up in inflation, thought to be around 5%. As discussed last week, the market's record in underestimating the strength of the labour market is legendary. Over the last five years there have been only 9 (now 10!) occasions when the market has overestimated the employment data by 10k or more and 35 when it has underestimated – the usual plus 10-15k market forecast next month looks to have substantial upside risks.
Overall we assess this week's data as consistent with a May rate hike with the new finance numbers indicating the effect of the unwinding of a stimulus package rather than anything more fundamental. Bill Evans, Westpac Chief Economist