US monetary policy still has plenty of heavy lifting to do

We know that the US and Australian economies are very similar in that economic activity is dominated by private consumption (>60%). However, when monetary policy needs to shift private demand up/down, there is a major difference between Australia and the US.

Households in Australia largely borrow for housing through variable mortgage rates, whereas in the United States, they borrow with reference to the 10-year fixed rate (and can readily refinance as these rates lower, and remain unchanged when they rise).

The implications for monetary policy are quite stark:

• In Australia, increases in the cash rate have a fairly immediate transmission to variable rate mortgages, albeit, with some lags as consumers adapt to the scale of the impact on their cash flow. Importantly, it impacts all households with variable rates plus the next marginal activity for households, be it a new mortgage or new car finance, and for businesses through their reference rate

• In the United States, increases in the Fed Funds Rate have a more muted effect on existing borrowers who are largely tied to existing fixed rate mortgages. The impacts, therefore, are largely on the marginal next household borrower – either the next house finance or car finance, as well as business borrowers, who are subject to shorter-term finance

To hear Paul's thoughts, watch the interview below:

In the US, households are in quite good shape. We can see this through still available savings build-up from the COVID period (refer graph) although, as a whole, households have locked in low fixed rates from the COVID period.

US households have a very low interest burden as a percentage of their disposable income – in fact, it is the lowest since 1962. For businesses, particularly large listed businesses, the same is largely true as they took the opportunity through COVID to lock in low, long-term rates with long maturity profiles.

So why is this bad? For the activity economy, it isn’t. However, given existing borrowers are largely unaffected by rate increases, for the Fed Reserve to achieve its demand dampening, it is largely directing policy to the marginal next economic activity. This invariably means the policy has to be more aggressive and in place for longer to have a macro impact on something like inflation.

The recent, still positive jobs report issued last week (Friday 7 October 2022) highlights that the Fed is trying to stop an economic “rhino”. It isn’t easy. The risks are:

• Acting aggressively in too short a time frame whilst the lag effects are still working through the system

• Causing undue pain on the business sector who are wholly exposed to the marginal activity – the next house build, the next purchase, the next car finance

• Corporate earnings bear the brunt of the pain, but particularly the small to mid-business sector

• A recession

We think these risks are likely in the US, but do make the point that household, corporate and financial sector health is good and that any recession is likely shallow and highly unlikely to present material systemic issues.

In Australia, we recently saw the Reserve Bank of Australia moderate its rate increases. This moved the cash rate to 2.6% pa, our assessed point of pain, and with a likely further 50 basis points before Christmas, the RBA is right to assess the lag effect or potentially destroy swathes of household wealth. As we have noted here, the RBA does not need to wait as long as the US Federal Reserve due to the more immediate transmission of rate increases to households (and accompanying falls in household wealth).

Our expectations are that longer-term bond rates will moderate in Australia sooner than in the US. In this regard, we view an asset class like listed property, and more specifically industrial property, as attractive. Unlike equities, it represents a solid pathway with a healthy 3 to 5 years earnings profile combined with low gearing historically and physical constraints on new supply (costs of land and construction, zoning and approvals). With a 2023 10-year bond rate at or under 3% and listed property forward yields of 7% pa, this is attractive.