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Dilemma In Oz: RBA Against Consumer Distress

By Chris Shaw

Today the Reserve Bank of Australia (RBA) is expected to again lift official interest rates, continuing its policy of normalising the rate setting environment after the extraordinary easing put in place in response to the global financial crisis. Further hikes to the cash rate are expected in coming months, Westpac senior economist Matthew Hassan noting the market is pricing in 225-basis points of increases by the end of 2010.

These expectations are far too aggressive in Hassan's view as he notes such an increase in the cash rate would push the standard variable mortgage rate to more than 8% by the end of next year. This compares to a long-run average rate of 7.25%. Such an increase would lift household debt servicing to around 15.4%, a level Hassan notes is in line with the highs seen early in 2008.

It would mean mortgage rates are below their 2008 peak of around 9.6% but the difference as Hassan notes is Australian households are now more interest rate sensitive, with household debt projected to increase by 17.5% between June 2008 and the end of 2010 against a total rise in disposable income of 5.4%.

Assuming the market's implied tightening of 225-basis points was correct, Hassan estimates the average household debt servicing ratio for Australia's "mortgage belt" would increase to more than 30%, which would present quite a challenge as the last time such a level was reached mortgage arrears rose sharply in the following six months.

In Hassan's view this suggests the RBA will attempt to avoid causing a similar level of household financial stress as was experienced  early in 2008, which implies the adoption of a more cautious approach to the timetable for lifting interest rates. Rather than an ongoing series of increases Hassan expects there will be an initial set of rate hikes followed by a significant pause.

On Hassan's numbers, a cumulative rise of 150-basis points by mid-2010 is likely, followed by a pause for the rest of the year. This would strike something of a balance between putting pressure on the household sector given mortgage rates of more than 7%, which historically is the level at which rates start to bite on household budgets, without triggering major financial difficulties.