The sheer scale of Australia's household debt means lifting interest rates is going to be a far more sensitive operation than previous tightening cycles.
At present, just two economists think the Reserve Bank of Australia will hike rates this year as it frets about hefty mortgages and financial stability. Goldman Sachs and TD Securities both expect a single quarter-percentage-point increase in the fourth quarter, while traders are pricing in a 30 percent chance of a December hike.
But consider a hypothetical scenario where the Federal Reserve turns aggressive in lifting rates, the Australian dollar tumbles, and the RBA seeks to tame a subsequent boost in inflation with monetary policy: too much household debt would pose a risk of the central bank crushing the economy with the hit from rate rises.
James McIntyre, head of economic research at Macquarie Bank, has run the ruler over previous tightening cycles in the mid 1990s and turn of the century, the first of which involved 11 quarter-point hikes. He found that the subsequent surge in households' debt servicing ratio -- interest costs as a portion of disposable income -- would be achieved with less than a third of those hikes today, thanks to record high private debt levels.
``The RBA's reticence about further increases in household debt-to-income ratios is clear when you begin to consider how potent interest-rate rises might be from a debt-servicing perspective,'' McIntyre said. ``At the current level of debt-to-income, we estimate that three to four 25 basis-point rate hikes would deliver a bigger increase in debt-servicing costs for households than 10 to 11 rate hikes did in the mid-1990s.''
McIntyre, who doesn't expect a rate increase until early 2019 when core inflation is likely back inside its 2 percent to 3 percent target, notes the other difference between the periods is a wider spread between the cash rate and lenders' mortgage rates: from 180 basis points to about 375 basis points.
Macquarie estimates that given households’ debt levels -- currently at a record 187 percent of income -- a one percentage point increase in the RBA's cash rate would, in the absence of further increases in lenders' borrowing rates, push the household debt servicing ratio beyond 10 percent.
Frontier Advisors, an asset consultancy for institutional investors, similarly said this week that while Aussie household debt serviceability is currently manageable given low rates, the key risk is when they increase. That's down to the limited capacity for households to accommodate higher borrowing costs.
Its modelling suggests Australian house prices are 15 to 20 percent overvalued, and that a rate rise of more than 1.5 percent would imply a higher level of overvaluation -- at which point a correction would become more likely. The Melbourne-based consultant said it doesn't expect a house price collapse.
``Given the sensitivity of the housing market to monetary policy, this is likely to provide a cap on how high interest rates will rise going forward,'' said Chris Trevillyan, director of capital markets and asset allocation research at Frontier. ``The RBA will avoid triggering the kind of house price collapse that will have a major impact on bank capital.''