Rates Will Need to Go Higher to Tame Inflation

The RBA will all but certainly be raising interest rates again this afternoon (by 50 basis points to 2.35%) and there have been various commentators suggesting that it's time for a pause in rate increases, or we are approaching the peak.

I don't think this is right, bond market expectations for peak rates have been pegged between 3.6% and 4.0% for months now and, there are strong indicators that the fight with inflation is far from done.

Let's run through a couple...

Petrol Prices are Going Back Up

Petrol prices have retreated somewhat from their highs in June, but petrol prices in Australia are set to go back up over the rest of 2022, for two reasons. 

First, the Liberal’s vote grabbing petrol excise but will end on 28 September. Instantly adding 23 cents to the cost of a litre of petrol - this is good for a 0.25% jump in CPI all on its own. 

Second, overnight OPEC+, the cartel of oil producing nations decided to cut oil production to boost prices. This cut will take a few weeks to work through the international trade system, but is worth a another 4 to 6 cents per litre by the time it gets to bowsers in a few weeks. 

There isn't much hope of relief in 2023 either. Sooner or later China will have to abandon their pursuit of COVID-Zero and when they do, we will see a significant spike in demand for oil from China.

The Explosion in Rents Hasn’t Hit Inflation Yet

Australia’s rental crisis is no secret but the steep rises in rent are yet to flow through to official CPI numbers. Rents in major capital cities are up 19.5% YoY and are likely to go higher as over leveraged investors push up rent to cover for rising interest costs.

When the full rental rise flows through to inflation, it will account for another 1.2% increase in CPI all on its own.

Wages Growth is Slowly Picking Up

While wage growth remains well below inflation, there are signs that workers are starting to receive wage increases to catch up with inflation.

Wages across all industries were up 3.3% last quarter and NAB’s more recent business survey reported labour costs growing at 4.6% in July. While this is better news for workers, as it trims declines in real wages, it will also place continued upward pressure on inflation. 

This is another trend that will not be going away anytime soon. With unemployment super low, and workplace participation near all time highs, there's going to be increased pressure on wages for the foreseeable future.

The USD is Dominant

The US dollar is currently at all time highs against other currencies and is due to climb higher, with the US Fed more aggressively raising rates than the rest of the developed world and capital continuing to move to the safe haven of the US dollar. 

With so much of international trade denominated in US dollars, the continued weakening of the AUD against the USD will mean higher import prices and further inflation pressures in Australia. 

Most Mortgage Holders are Immune to Rate Increases (For Now)

Most Australian mortgage holders just aren’t being impacted by rate increases yet. More than 40% of mortgages are fixed at ultra low rates and will remain there for almost two more years, while 35% of those on variable rates would seen no impact to their repayments from a cash rate at 3.35%, due to pre-payments, large offset accounts, or voluntary extra repayments. 

With so much of the mortgage market effectively immune to interest rate increases until the cash rate gets to around 3.5% the RBA will be forced to go higher with interest rates to bring inflation under control. This is going to be very hard on the approximately 28% of variable rate mortgage holders who are very susceptible to rate increases.