Inflation Forces RBA to Hike Rates, but Housing Market Defies Gravity

Posted by Gavin Chau

A surprising increase in inflation to 6.8% in April has forced the RBA to raise rates by 0.25% once again. While I don’t see any good reason for the RBA to make this move, the RBA governor Philip Lowe might be erring on the side of caution. If he raises rates and the economy starts to break, he can easily cut them again quickly. If he’s not confident that inflation will be under control with what he’s already done, he will need to raise them even higher later on, and the media will slaughter him.

Despite this, house prices in every capital city are creeping higher regardless of interest rates being the highest they’ve been in a decade. The relatively small volume of tradable housing stock combined with the sheer size of the supply-demand imbalance has been big enough that it offsets the effect of tightened liquidity. Nationwide house prices are up 1.2% in May, the third consecutive monthly increase indicating that the housing market has likely carved out a bottom. At the moment, the housing market is like a beach ball being held underwater. As soon as the RBA takes its foot off the brakes, it will explode higher.

One interesting thing to note about the monthly inflation report is that it measures fewer things than the more accurate quarterly report since not all the components that make up inflation are collected monthly. As such, nobody (including the RBA) is sure how seriously to take the figures. If you delve into the depths of the methodology, the monthly inflation figure only considers somewhere between 42 and 63% of the entire basket of goods and services that are measured for inflation compared to the quarterly figures.

Additionally, much of the inflation was driven by the unwinding of the fuel excise duty, which was halved in April 2022. Fuel prices were 9.5% higher this month than they were in April 2022, when prices were discounted by 22 cents per litre. If we were to look at the CPI (excluding volatile items), the April figure is 6.5% – lower than the 6.9% recorded in March.

The RBA sits between a rock and a hard place. On the one hand, not raising rates high enough risks higher inflation levels (which would ultimately necessitate even more rate rises). On the other hand, raising rates too high risks sending the country into recession or worse. In a weird twist, the solution to higher prices is higher prices. This is made more difficult by the fact that the March GDP data comes out tomorrow – the day after the RBA board meets. There’s a reasonably high chance that it will confirm that we have already experienced a recession in per capita terms, with GDP per capita coming in at 0% for December (with the potential to be revised lower) and the March quarter figures likely to come in at -0.2%.

It becomes increasingly difficult to know what the RBA will do next at these inflection points, but one thing we do know is that if we’re not already there, we are close to the end of the hiking cycle. Given that there is an 18-month lag between the interest rate moves and their effect on the economy and the high level of indebtedness of Australian households, the RBA has almost certainly already done enough to bring inflation down. After peaking in December 2022, there has been a clear downtrend in inflation. There is no evidence that the RBA requires further rate rises, with every forward indicator showing inflation falls off a cliff this year.

Posted by Gavin Chau, on 6th Jun 2023