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Former RBA Governor's interest rate and mortgage cliff warnings

This is an edited transcript of an interview between Stanford Brown CEO Vincent O'Neill and former RBA Governor and Stanford Brown Investment Committee member Ian Macfarlane.

Vincent O'Neill: Where do you see inflation now versus where we were 12 months ago?

Ian Macfarlane: There has been progress made on inflation, particularly in the U.S. So it peaked at 9.1% and it's now 4.9%, which is quite a big fall. And the reason it's falling is that it's the transitory bits that jumped up, either stopped going up or are, in many cases, falling again, like energy.

But you should look at measures of core or underlying inflation. The most obvious one there for the U.S. is to take out energy and food. If you look at that, it never went up anywhere near as much as the total CPI and hasn't gone down much either. It's running about 6%. So that's a better indication of ...

US core inflation rate

O'Neill: Where true inflation levels are up.

Macfarlane: In Australia, our CPI has gone down a lot less than the U.S. CPI. But we have three different measures of our underlying inflation. Our underlying is also somewhere between 5% and 6% and so really, we've got to think of ourselves as being in a world where underlying inflation is probably somewhere between 5% and 6%.

O'Neill: Certainly quite a bit higher than where the central bankers would want it to be.

Macfarlane: A lot more.

O'Neill: Probably quite sticky at those levels as well.

Macfarlane: I think so, but the market doesn't. This is the interesting thing. The market has been optimistic on the economic outlook. It's also been optimistic on inflation, implicitly, we're not permitted to call inflation because we know that through last year, and it's also the case this year, the market has expected interest rates to go up a bit, but then start coming down within the year. 

O'Neill: Cuts before Christmas.

Macfarlane: Early fall in interest rates that could only happen if there was a pronounced fall in inflation and which I don't think is going to happen. In that sense, I think the markets have got it wrong. They're too optimistic on both activity going up and inflation coming down. Some people have used this phrase ‘immaculate disinflation’, a play on immaculate conception. In other words, you can have disinflation without any other bad things happening.

O'Neill: Some magical outcome.

Macfarlane: Yeah.

O'Neill: Very tall scenario. Do you think perhaps markets are reading central banks resolve, misreading, I should say, the resolve of central banks in terms of balancing. How hard they want to go…

Macfarlane: I think they have all the way along. I can remember when we first started putting up interest rates in Australia, there were economists [saying] the cash rate couldn't go up by more than 1.5%. It’s gone up by 3.75%. I think the central banks are more determined than markets give them credit for.

O'Neill: And they are not going to be comfortable with allowing inflation to lead.

Macfarlane: Powell made a speech where he just said quite bluntly, yes, it might cause a recession, but that would be a lesser harm than having inflation just continue entrenched in the system.

O'Neill: It's possibly happened, they didn't act fast enough or strong enough.

Macfarlane: Yeah, they already were a bit too timid at the very beginning because a lot of central banking and particularly academic economists got sucked into this belief between 2010 and 2021 that we had entered a new world of permanently very low inflation, possibly even risks of deflation. And we will be in a permanently low interest rates or in some cases 0% interest rates. That became very widespread, and it was a shock to them how quickly it turned around. Having been caught a little bit behind, they're determined that, as Powell said, he'd prefer to go down as someone who caused a recession than as someone who allowed entrenched inflation to continue.

O'Neill: So you paint a picture inflation is sticky, interest rates are higher and will need to remain higher for longer. Maybe we step across and start to think well, okay, what is the impact of this composition, what's the impact on the real economy. And I'm thinking here in Australia, with possible debt levels and we've heard a lot about this fixed rate mortgage cliff that we are on the cusp of. How do you see the outlook, if you were a central banker in terms of the likely impact to the real world?

Macfarlane: We'll work our way towards it. As I said I would have thought there'd been more impact by now. The central question you have to ask yourself is with the increase in monetary policy to date and in my view probably future increases - is it going to bring about a major slowing in economies and possibly recession? I think there is a lot more to come.

O'Neill: Surely it must.

Macfarlane: I mean the adjustment to date has been quite minor. There must be more to come. I think you have to be cautious, you have to say that the markets are more optimistic than they should be, the outcome is probably going to be worse than they think. And how's -- what's the form it's taking? Well, you don't really know how they adjust -- what form the adjustment will take, particularly in financial markets.

Now … the U.S. system where the banks are the ones that are under pressure and part of that is because of the structure of U.S. banks where obviously the deposits are variable. If you want to keep your deposits, you have got to put the interest rates up where competitors are. But so much of your lending book is absolutely fixed in 30-year mortgages, which have been taken out in the ultra-low interest rate period and everyone has got an ultra-low.

O'Neill: No one's rushing to refinance in this environment.

Macfarlane: That’s right. So that puts the pressure on the banks.

O'Neill: They've got lower income from that, but rising cost of capital.

Macfarlane: Yeah. Now in Australia it's the other way round. The banks are in very sound position because both on the deposit side and the lending side, there's variable interest rates. You don't get squeezed. What you lose on one, you gain on the other. But what that means is it puts the pressure on the borrower because the borrower, unlike the U.S. borrower, who sits on their low interest 30-year mortgage, the Australian borrower in most cases is either on a variable mortgage or if it's a fixed rate mortgage, it's only a 3-year mortgage.

O'Neill: So that's the point we're at right now, where the those that were fortunate enough to be on the 2, 3-year fixed mortgage are now coming towards the end of that, and realizing they're heading for rates at least doubling, likely more.

Macfarlane: And the problem is let's say they've got, for arguments sake, an $800,000 mortgage, which is quite common these days. And they're going to have to come to the end of the three years. They’ve got to pay it back. And the idea is you roll it out; you go and get a different mortgage - a new variable rate mortgage, probably to try and pay back the old one. But at this higher level of interest rates, you cannot borrow $800,000. You're only eligible to borrow $700,000 because the servicing costs determine the size of the mortgage. Clearly there's a potential for serious problem there. It'll be resolved by both the bank [and] the borrower taking a haircut, probably APRA [the prudential regulator: ed] have to bend a few rules, and conceivably, in the last resort, the government having to step in because no one wants…

O'Neill: That's quite an extreme situation for the government to step in.

Macfarlane: I think they would.

O'Neill: I think they certainly would if that was required.

Macfarlane: I mean there’s hundreds of thousands of people with fixed rate mortgages that are going to mature, and if half of those were not able to get new funding to pay out their old loan, it would be serious issue and the last thing the banks want to do is just foreclose.

I think the borrower is going to have to pay more if they are coming out of a low fixed rate. They're going to pay a lot more. And quite possibly APRA is going to have to relax the rule that says when you work out how much you can borrow, you've got to assume that interest rates could rise by 300 basis points.

O'Neill: Very sensible rule when rates are 0%.

Macfarlane: That's right. Maybe you don't need as big a buffer as 3%. As I say, I think if it really got nasty, there would have to be some form of additional lending coming from the government.

I think it's the pressure point in Australia and this is the problem. The biggest effect of tightening monetary policy is on anyone who's got a lot of borrowing. And in Australia, that is the household sector.

 

This is an edited transcript of an interview between Stanford Brown CEO Vincent O'Neill and former RBA Governor and Stanford Brown Investment Committee member Ian Macfarlane.

James Gruber is an Assistant Editor for Firstlinks and Morningstar.com.au. This article is general information.

 

10 Comments
John
July 07, 2023

Any borrower who was unable to re-finance their residential housing loan would have either: (a) taken the original loan with 20%+ equity; or (b) have protected the bank against loss via LMI cover. Why is there any concern here about bank losses or the need for the government to step in? If the borrower can't pay, the bank gets paid either by Mr Market on resale following foreclosure or by the LMI insurer is that resale does not fully cover the liability to the bank, including all disposal costs. If there are a mass of foreclosures, maybe it's the insurer in trouble rather than the bank. Any reposted property will be rapidly sold, due to lack of listings and there are plenty of investors willing to buy for the outstanding mortgage balance.

Steve
June 07, 2023

The Government are misleading the public by blaming the RBA for raising rates. The Government policies are clearly inflationary and Mr Jones says, in todays press, that they are not. The Covid recovery was marked by the Government pumping too much money too fast into the economy which initiated inflation and then they won the election based on policies that gave more money away to the public in welfare rather than assisting business and industry. On the contrary, they have imposed significant extra cost and tax on business and industry in areas such as transitioning to green power.

John
June 05, 2023

I wonder how many of those requiring refinancing off honeymoon 2% RBA TFF-enabled fixed rate loans are residential housing investors? There is no justification for government intervention there. Just let them sell if they can't refinance. Real estate agents will be pleased, as will the ATO. CGT will be triggered along with a fresh lot of stamp duties.

Adrian
June 03, 2023

How has Japan not raised interest rates and yet their inflation curve is tracking the same as countries that have raised interest rates. Maybe this suggests this time around things are different. Energy prices and some commodities are impacted by supply issues from the Ukraine war. Floods have impacted food prices. Floods have caused a demand for materials for those that need to rebuild. The China lockdowns have restricted supply of other materials and products. The inflation experienced in Australia (and the rest of the modern world) is not brought about by over spending, but rather a temporary supply issue brought about by the above factors that excessive interest rate rises will not rectify (although every traditionalist will beg to differ). The mere fact that energy prices and food prices have gone up reduce the spending power of households. Surely this is already doing the job that raising interest rates is attempting to do. Inflation will naturally come down in time with supply increasing in a post pandemic and post war time environment. In the interim if it is seen as necessary to reduce surplus discretionary income for the sake of taming an inflation that may or may not be endemic can my employer take out more super from my weekly wage? That way at least I might see my hard earned income again at some stage instead of it going straight to the banks bottom line never be seen again. Hang on, a central bank making policy that benefits banks. Go figure. Go Japan. You stay the course. Wish I was there right now!! Australia the not so lucky country.

APRA update
June 02, 2023

On the buffers, APRA told the Senate Economics Legislation Committee this week: “We are attuned to concerns for some borrowers who may have fewer options for refinancing their existing loan with another lender, for what could be a variety of reasons. For some, the impact of rising rates may have resulted in less favourable serviceability results. Others might be impacted by declining house process or changed personal finances.

“Where sound borrowers do not fit standard lending criteria, APRA’s framework does not prohibit banks from lending to these borrowers. APRA expects banks to have prudent limits, controls and justifications for exceptions to lending policy and for these loans to be monitored closely.”

Glenn
June 30, 2023

There are always sound reasons for the floor and the buffer and the way they relate (which is why it’s in APRAs PPG). That said, the author of that would acknowledge that you could probably revisit the levels depending on what forward curves were felt to look like ( that said…getting future rates wrong tends to kill you). Plus also APRA has countercyclical buffers and PCR levers to pull, as part of this. Also written into the PPG is some ability to use reasonable judgement to approve outside” policy’ in some (smaller) number of circumstances. Very rigid ( Stalinist) credit policy isn’t the best idea. The big challenge for Line 2 Risk types is around how you control that…. Lest the (louder) Line 1 voices suddenly find 3 million similar exceptions to policy, unbalanced as they are by sales based scorecards.

CW
June 02, 2023

Oh, what a nice fresh perspective, whilst Australia has one of the lowest cash rates in the oecd demand for the dollar is low and we are inheriting imported inflation on many imported goods.

The impact on the housing market is a tough one, demand for housing with high migration outstrips supply in a lot of regions without tough new housing policy I don’t see this being fixed anytime soon resulting in sustained high rents and high purchase prices.

I don’t see the government needing to step in any further than they have.
Alot of these high debt loans are for first home buyers which the government has acted as guarantor with the fhlds, so the banks have a significant buffer if the housing market did drop, it would need to drop significantly before further government intervention is required. I agree at this point that apra should begin to revise their 300 basis points to reduce the impact of the fixed rate cliff inconing, action on this would serve the housing market better if acted on sooner rather than later. Whilst rates have more climbing to go, we are past the point of requiring 300 basis points in buffer.

Stephen
June 02, 2023

Thank you Mr Macfarlane. That’s telling it like it is. It stands in contrast to the bland self serving nonsense that is served up by economists who are really PR figureheads. Australia has a serious inflation problem with a host of policy settings pointing to high sustained inflation. Couple this with high household debts and a fragile world economy and the outlook is not the Pollyanish view often given in the financial media.

LP
June 02, 2023

Government intervention seems a radical step. Has it ever happened before in Australia? How would it operate it practice?

Chris
June 07, 2023

Just like every other time in every other country. They would bail out everyone else who has been irresponsible whilst those who "did the right thing" get nothing but a slap in the face. For example, being an 'essential worker' during COVID, some of us were still at work while the rest of the nation was on JobKeeper and furlough; a mate of mine joked that all he did was pull money out of his super to buy a new car, watch TV and play tennis, and get paid for it - he thought it was great. An absolute slap in the face for those who did the right thing.

 

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