Are central banks weighing the economic pain of rate hikes?

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May 10 2022
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The hype around interest rate hikes usually centres around the urgent and fundamental need to alleviate the consequences of inflation – but does this monetary policy do more harm than good?

It’s no secret that mortgage holders are the biggest victims of a central bank’s decision to hike interest rates, as they often find themselves faced by bigger loan repayments than they might have initially budgeted for.

Central banks across the globe are presently recalibrating the direction of national monetary policies, as exemplified by the Reserve Bank of Australia’s (RBA) recent decision to raise interest rates from a historic low of 0.1 per cent to 0.35 per cent and the Federal Reserve’s choice to enact the largest hike in decades, all with a common aim to reduce the effects of inflation.

Historically, setting the interest rate to a level that reverses the course on generous government policy has proven effective, but are central banks ignoring the potential long-term economic pain that a rate hike may inflict?

AMP chief economist Dr Shane Oliver doesn’t believe so – rather, he feels that potential economic pain weighs heavily on a central bank’s decision to lift the cash rates.

“They have a dual mandate to aim for price stability but also full employment, so they certainly do take into account financial hardship,” Dr Oliver said.

Describing a central bank’s role as a “balancing act”, he said the present problem of inflation is causing hardship for households and businesses because costs are rising – “but by the same token, we also know that if central banks don’t get it under control, it’s going to cause even more hardship.”

And that balancing act creates a significant dilemma for central banks, according to Dr Oliver.

He said central banks know if they don’t get inflation under control, they’ll have a much bigger problem, and virtually the only lead they have is to raise interest rates.

“In other words, to tighten monetary policy – because it increases the cost of money, and acts to slow down demand growth in the economy – that’s what they’re seeking to do but it does have the unfortunate effect of taking spending power away from the nearly 40 per cent of households that have a mortgage,” Dr Oliver said.

This dilemma places central banks in a difficult position because “there’s not much more they can do about that”.

There’s also the problem when interest rates are raised too high, they potentially place mortgage holders in the position of having to sell or even face the prospect of having to default on their loan – but Dr Oliver said there are contingencies for those events.

“It is a significant risk and it’s why it’s next to impossible to predict how high interest rates will go because that is the key thing the RBA will be watching,” Dr Oliver said.

He said that the RBA only wants to raise interest rates enough to “cool things down” and to get inflation under control.

“It’s not on autopilot here – this is not 1989 when debt levels were a fraction of what they are today, and therefore interest rates went to 17 per cent,” he said.

He offered a relieving assertion that the RBA will not be doing that – “they will only raise interest rates as far as necessary, and as soon as they see signs that there’s a big increase in defaults or lots of people really struggling on their mortgage to the point that they’re likely to miss payments or might have to sell their house, then that’s when they will pull back,” Dr Oliver said.

He said at some point, if interest rate hikes start to cause issues within the housing sector, that may be a sign that the RBA has “done enough”.

Dr Oliver also reminds that APRA requires banks to assess any borrower on the basis of their ability to pay a mortgage rate of 3 per cent above the rate of which they’re signing up for.

“So if you show up and your mortgage rate is 3.7 per cent as the going rate, the bank will assess you on the basis of 3.7 per cent, plus another 3 per cent, at 6.7 per cent,” he said.

“They’ll want clear evidence that you can keep your payments going when rates are 3 per cent higher.”

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