Currently standing at 2.6%, with the prospect that by year end the cash rate will be 3.1%, we believe the peak cash rate could be 3.6% by mid 2023. The Futures market is higher again. Any further increases from where we are currently would be materially harmful and risk a recession with significant destruction in household wealth.

There are five major items we would identify as being critical in the RBA's policy settings going forward:

The increase in cash rates by the RBA have a lag effect before their impact in changed demand patterns occur. Banks normally increase mortgage payments a few months after raising rates which defers the inevitable pain. This, combined with the savings build-up through COVID (refer chart below) sees households about to realise the double whammy of savings evaporating with sharp increases in mortgage costs and non-discretionary costs. We are now at the end of the lag, and the beginning of the contraction.

If the current strong data for population growth, labour force and visa issuance is maintained, the economy will return and exceed the pre COVID labour force. Together with a moderation of the great resignation, this would dampen wages growth and inflation pressure. We are seeing these data trends through student visas, skilled/temporary visas and permanent immigration visas (refer chart below). If the current trend is maintained, this will approach 400,000 to 500,000 over the next 12 months. For the last 12 months, the population has grown 1% from its COVID trough. Government policy still likes (loves) immigration. State and Federal Budgets need the population growth 'sugar fix'. The cost is low real wages growth, low per capita growth, strained public services, but the upside is lower interest rates and increased tax revenue. If immigration growth does significantly materialise, then inflation will be a rear-vision issue and the economy will look & feel like pre-COVID. This will have significant implications for property, rents and prices as inflation and interest rates moderate.

With mortgage financing already 3 times where it was 12 months ago, combined with non-discretionary cost increases, and a further significant number of mortgages moving from fixed rate to variable rate, indebted households are only now starting to experience significant cashflow burdens - monetary policy has a lag effect starting after 3 to 6 months. The level of household indebtedness in Australia subject to variable rates is extremely high, and the transmission of high rates has a short lag from which we can see reduced private demand. Financial conditions are already restrictive. Analysis indicates that given the current level of household debt, a 2.5% cash rate today is the equivalent of 7.25% in 2008 (which would be a mortgage rate of over 9%). The mortgage burden ‘worm’ is starting to turn upwards (refer chart below).

At a cash rate of 2.5%, household wealth was modelled to decline $1.5 to $2.0 trillion from a total household wealth pool of $9.9 trillion or between 15% to 20%. Moving to a 3.6% cash rate or let alone 4% rate would be catastrophic for household wealth and the economy. Commentary by the Deputy Governor, Michele Bullock seems to draw an overly optimistic assessment of the household's ability to absorb higher mortgage rates due to pre-payment buffers. There is some capacity, but it is finite and those who have (re)financed or accommodated themselves based on the RBA's 2024 rate ceiling will not be as sanguine as the Deputy Governor. There is a significant volume of fixed to floating conversions that will occur over the next 12 months and mortgage repricing up 2.5% from 12 months ago and climbing.

We are less critical of the RBA through COVID, other than to say, once the early understanding and circumstances changed through vaccination, scientific data, and responses in other western economies, policy here should have been adjusted. In this respect, the RBA could be accused of being too politically tied in policy with the Federal & State Governments. Admittedly, they were not alone as central banks went. Like many, we are concerned at their analysis and policy settings since the GFC, 13 years ago. The danger is in the assumptions, and the RBA has a pretty crook record over the last 13 years in terms of wages growth and the neutral rate of interest (to achieve its desired inflation target range of 2% to 3%). This is an 'echo-chamber' problem with the RBA. Our concern is if they are anchored to these same assumptions, policy will tighten too restrictively.

So, in summary we view the RBA's recent slowing in rate increase from 50 basis points to 25 points as perhaps a tacit acknowledgement that the lag effects of policy will be observed before policy moves beyond a 3.1% cash rate (already highly restrictive). Immigration/visa data is a major factor that the RBA will need to calibrate into its policy settings. Pre-COVID, it concerned us that the RBA was extremely poor at reading & interpreting population growth data and the effect on wages growth and inflation. A failure to read this data correctly or simply to ignore it would likely see rates continue to rise well beyond a sensible level of restriction, and therein is the major risk. Will the RBA just take monetary policy on, in an inflation busting ideology, with a ‘damn the consequences’ outcome? In the US, we think this may be necessary, but it is not the case in Australia. The potential problem is the RBA is once bitten, twice shy. Having been heavily criticised for their policy setting well before and through COVID, they will simply seek to crush inflation and with it create a deep recession in Australia (as a self-validating necessary cost). This attitude draws from current US Federal Reserve rhetoric, but as we have noted, the circumstances in Australia are quite different to the US. We certainly hope the RBA can operate restrictive policy effectively and discriminate the differences.

For inflation, either through RBA stealth and/or labour force growth through immigration, we think the inflationary environment through 2023 will moderate. As for the cash rate, we see it lowering through the 2H of 2023. The actions of the RBA over the next four months will determine whether we have a modest growth/technical recession or a deeper, wealth destructing recession. For longer term interest rates (10-year bond rate), on the balance we think the environment will see the yield curve invert and deliver lower long-term rates through 2H of 2023 and into 2024. The significant moderation in longer term interest rates will be broadly welcomed by investment markets.