Don't panic; rates aren't rising to 3.5%, says Oliver

On Tuesday, the Reserve Bank of Australia (RBA) released the latest minutes of its monetary policy meeting, stating that the neutral cash rate is 3.5 per cent, two percentage points higher than what it currently is.

This optimistic announcement caused a strong market reaction, with the Aussie dollar increasing in value. Many mortgage holders were left to speculate that rates were going to rise again.

Shane Oliver, Head of Investment Strategy and Chief Economist at AMP Capital, has responded to the RBA statement in his latest weekly economic update report, calling the market reaction “way over the top”.

“Don’t read too much into [the neutral rate],” said Mr Oliver.

“The minutes certainty did sound a bit more upbeat than the initial post meeting statement about growth and wages, but the bit that caused most excitement was the reference to a 3.5 per cent neutral rate of interest.

“Some have interpreted this as indicating that a series of eight quarterly rate hikes of 0.25 per cent are imminent. This is very doubtful,” said Mr Oliver.

Should mortgage holders start panicking?

Shane Oliver doesn’t believe so. He draws this conclusion from a few key factors:

Firstly, the neutral rate discussion was just that – a discussion – and no significance should be read into the fact the neutral rate was brought up at the last meeting.

Secondly, the neutral rate is “a rubbery, rather academic concept,” said Mr Oliver. 

“While a comparison to some neutral rate may be of use in assessing whether policy is easy or tight, it’s not a firm target that central banks head for.”

Thirdly, AMP Capital assessed what they believe the neutral rate is, and because of higher household debt to income levels and higher bank lending rate spreads, the neutral rate is around 2.75 per cent.

Fourthly, a cash rate increase of two percentage points over the next two years would take a huge chunk out of consumer spending.

The cash rate increase would raise the ratio of household interest payments to household disposable income from 8.6 per cent to 12 per cent, and in Sydney and Melbourne it would be significantly higher.

Finally, the announcement alone pushed the AUD above US$0.79. A real cash rate hike to 3.5 per cent over the next two years would see the AUD soar, “exacting another round of damage on the economy just at a time when we still need a lower currency to offset the impact of still falling mining investment,” said Mr Oliver.

He believes it is far more likely that the RBA would make small, incremental hikes (i.e. 0.25 per cent) and then wait to assess the impact.

“We doubt that rates will be able to go as high as 3.5 per cent any time soon as the RBA won’t want to crash the economy,” concluded Mr Oliver.

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