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The US Federal Reserve is tightening monetary policy, and it's likely to impact Australian households - ABC News

Mortgage borrowers and renters may be slugged with higher monthly payments than even the most pessimistic forecasts currently suggest, and the Reserve Bank won't be to blame.

Instead, it's the US Federal Reserve that may absorb the wrath of Australian households.

The reason is simple. The more the US Federal Reserve tightens its monetary policy, or raises its Federal Funds rate, the more pressure is on the Reserve Bank to follow suit, regardless of inflation pressures here in Australia.

Pressure on the Reserve Bank grows because the wider the interest rate differential, or gap, between the US and Australia, the more downwards pressure there is on the Australian dollar, and the more upwards pressure on inflation.

That gap is now growing and the wider it gets the more pressure will be on the RBA to raise its cash rate more aggressively than it would otherwise, to stabilise or support the Australian dollar.

That's more pain for mortgage borrowers and renters.

First though let's look at what is essentially an interest rate dance between the US and Australian central banks – a dance where the US is "leading".

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Play Video. Duration: 2 minutes 46 seconds
Federal Reserve hikes rates for a third consecutive time(Carrington Clarke)

Central bank dance

The latest reading on US inflation showed underlying prices are rising by 6.3 per cent, which is still uncomfortably high.

The inflation pressures are familiar: rising petrol and energy prices, as well as food and general groceries.

But the US is also dealing with strong wage growth -- the pace of wage growth is the best it's been in about 20 years. So the threat of a wage-price spiral in the US is real.

The US Federal Reserve responded by raising its Federal Funds rate (our equivalent of the cash rate) by 0.75 percentage points.

And the signs point to the bank remaining aggressive with its interest rate hikes.

"The big shock … was the 'dot plot' which revealed an aggressive upward revision to projected futures rates hikes in coming months," said David Bassanese, BetaShares chief economist.

Coloured lines on a graph tracking interest rates over time

"The median forecast for the fed funds rate among fed members is 4.4 per cent at year-end.

"It means the [Federal Reserve] intends to hike by a further 0.75 per cent at the November policy meeting, and a further 0.5 per cent at the December policy meeting."

So, right now the Reserve Bank's cash rate target sits at 2.35 per cent, compared to the Federal Funds Rate "target range" of 3 per cent to 3.25 per cent.

This pulling up and away from the Reserve Bank's interest rate setting helped push the Australian dollar down this week.

David Bassanese
BetaShares Chief Economist David Bassanese.(ABC News: Dan Irvine)

Currency wars and inflation

The Australian dollar fell under 66 US cents this week – its lowest level in 2.5 years.

"At US66c, the Australian dollar has already fallen 13 per cent from its peak of US76c in April this year," Bassanese wrote.

It's generally accepted by economists that a currency needs to fall by at least 10 per cent for it to have a material effect on the country's inflation rate.

And the dollar is expected to fall further.

"My expectations is the Australian dollar will end the year at around US62-63c."

The higher a country's interest rate, all else being equal, the more upwards pressure on its currency, and vice versa.

The problem is a depreciating currency brings with it inflationary pressures, as imported goods become relatively more expensive.

So central banks need to keep one eye out on what their counterparts are doing.

Reserve Bank governor Philip Lowe after a press conference at the RBA head office in Sydney.
Reserve Bank governor Philip Lowe.(ABC News: John Gunn)

RBA in genuine catch-22

Now there's no question the Reserve Bank will increase its cash rate target again in October.

The question is by how much?

Given the strength of the labour market and persistent inflation pressures, it's likely the RBA will raise its cash rate target by another 0.5 percentage points.

But here's where it gets tricky.

The Reserve Bank is not on a "preset" path, meaning it will be guided by how well the economy is coping with already announced interest rate decisions.

"The board expects to increase interest rates further over the months ahead, but it is not on a pre-set path," RBA governor Philip Lowe noted after the September interest rate decision.

"The size and timing of future interest rate increases will be guided by the incoming data and the Board's assessment of the outlook for inflation and the labour market."

But David Bassanese insists it's not that simple.

He argues that regardless of what the domestic economic data presents to the Reserve Bank, it's eyeing the Federal Reserve's moves.

"As regards Australia, continued aggressive Fed rate hike suggest the RBA will remain under pressure to follow suit."

"Indeed, given the Fed's aggressive stance, it now seems more likely than not that the RBA will lift rates by 0.5 per cent in October – as one emerging extra consideration is to limit potential further declines in the Australian dollar which would add to imported inflationary pressure," Bassanese says.

It puts the Reserve Bank in a particularly awkward position.

If it raises the cash rate target to keep pace with the US Federal Reserve it risks seriously damaging the local economy, given Australian wages are not rising anywhere close to what they are in the US, and Australians hold comparatively more personal debt.

However, if the Reserve Bank doesn't match the Federal Reserve in terms of interest rate increases, it risks a lower Australian dollar generating significant imported inflation.

Shane Oliver in his home office in Sydney in November 2021.
AMP Capital chief economist Shane Oliver.(John Gunn.)

“The main argument for following the [Federal Reserve] is that if the RBA doesn’t the Australian dollar might crash,” AMP’s chief economist Shane Oliver says.

“Of course, if the Australian dollar crash to say $US0.50 and brings Australian inflation up to US levels then it may be harder for the RBA – but it's also worth noting that strong commodity prices are providing a bit of an offset to the negative impact [on the Australian dollar] of the Fed hiking more than the RBA.

"To my mind there is ongoing pressure on the Reserve Bank to keep raising interest rates."

Recession risks loom

But, he says, Australia risks a "severe recession" if the Reserve Bank raises interest rates higher than it would otherwise consider in an attempt to keep pace with US monetary policy.

That's strong language, but you only need to look at some basic mathematics to see his point.

Westpac mortgage borrowers, for example, will be paying an extra $1,362 each month on a $750,000 loan if the cash rate hits 3.35 per cent.

That equates to over $16,000 extra a year.

That cost will grow significantly if the RBA is forced to follow the Federal Reserve higher, potentially by thousands of extra dollars.

The Reserve Bank knows well the tightrope it's walking on monetary policy.

"Members noted that an important source of uncertainty continued to be the behaviour of household spending," the RBA recently noted.

"Many households had built up large financial buffers and the saving rate remained higher than before the pandemic [however] … members acknowledged that other households were finding conditions difficult in the face of higher interest rates and higher inflation."

Mortgage borrowers and renters, whose landlords are still paying off a mortgage, are now well advised to keep a close eye on what both the Reserve Bank and the US Federal Reserve are doing with their interest rate settings.

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2022-09-23 19:00:00Z
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