Don’t panic. The RBA’s 3.5% rate goal doesn’t mean your mortgage is about to rise

Reserve Bank of Australia Opinion Greg Jericho The bank might want one day to get its cash rate to that level but it won’t m

Australian housing




‘Because the cash rate is currently 1.5%, investors took it as a sign that the RBA is going to raise rates.’
Photograph: Dan Peled/AAP

On Tuesday the latest minutes of the monthly Reserve Bank monetary policy meeting were released, announcing that the RBA considered the neutral cash rate to be 3.5% – some two percentage points higher than the current rate. This news sent the market into a spin, causing the dollar to shoot up in value. But mortgage holders need not panic. The RBA might wish to get the cash rate to 3.5% but the economy would have to perform a lot better than it is, and for a long time, for that to occur.

The inclusion in this month’s RBA minutes of a discussion on the “neutral real cash rate” was always going to create a reaction. The neutral real cash rate is essentially the cash-rate point above inflation where it is essentially having no impact on economic growth. This is important because it reflects – all other things being equal – whether the RBA is trying to speed up or slowdown the economy.

The minutes noted that “the rate had been broadly stable until around 2007, but had since fallen by around 150 basis points to around 1%”. Given that the RBA pitches for an inflation rate of 2.5%, the minutes noted that “this equated to a neutral nominal cash rate of around 3.5%.”

This sent the markets into a tizz – the Australian dollar rose 1.2% to reach a two-year high of US$0.79:


The reason is that because the cash rate is currently 1.5%, investors took it as a sign that the RBA is going to raise rates.

But what it really showed is that currency markets like to jump at shadows.

Of course the RBA would think the neutral rate is higher than it currently is – we are experiencing record low interest rates, and we have them because the RBA is doing what it can to bolster investment at a time when mining investment is going through the floor.

Talk of interest rates being two percentage points higher than they are now is of course going to cause conniptions if you hold a mortgage. It would send the average mortgage rate from 5.25% to 7.25%. For a mortgage of $400,000, that would equate to paying an extra $522 a month.

And it would absolutely send many households to the wall and would destroy the economy.

But don’t worry. It is not about to happen soon.

First off, the setting of the neutral cash rate at 3.5% is not all that surprising – even though for most of the past 25 years the cash rate has been above that level:


On the one hand, this appears like there has been a big shift in the level of the cash rate – 3.5% just 10 years ago would have seemed like a rate almost impossibly low and only associated with a recession.

But the RBA sets the cash rate because of the impact it has on banks’ interest rates, and here a standard variable rate of 7.25% does not appear as absurdly low – in fact it is slightly above the average rate over the past 20 years of 6.85%:


The reason for this discrepancy is that over the past 10 years the gap between the cash rate and the standard variable mortgage rate has grown due to the increasing costs of bank funding during and after the GFC:


Prior to the GFC the gap between variable mortgage rates and the cash rate was about 1.8% points, now it is 3.75% points:


Thus, for the RBA to get rates down to where they are now, they have had to cut the cash rate by a lot more than they would have had to in the past.

But that the cash rate is below the “neutral rate” only means that at some point in the future the RBA would like interest rates to rise – should other factors permit.

And those factors are not present at the moment.

Generally, the RBA takes its time when raising rates – during the mining boom, when the economy was going gangbusters, it took nearly four and half years for the RBA to raise the cash rate two percentage points from the then record low of 4.25% in April 2002 to 6.25% in November 2006.

It also occurred with the economy performing much better than it currently is. And while you could argue that was a case of the RBA raising rates above the neutral level in order to slow the economy, even if you were to suggest the RBA would like to get to a neutral or average position, the current state of the economy is well below that state.

The current growth of GDP, employment, full-time employment, inflation and wages is not only well below that observed when the RBA raised rates by two percentage points during the mining boom, it is below the average observed over the past 20 years:


The crucial measure is real wages growth. The RBA likes to increase interest rates when real wages are growing – but real wages have been falling:


And while the recent 3.3% minimum wages increase might flow through to an increase in overall wages, which might cause the RBA to raise interest rates slightly, that is still a long way from a two percentage point increase. For that there would need to be consistent and strong wage growth.

The reality is the RBA will not shift on rates until wages start rising consistently faster than inflation and when it is confident raising rates will not hurt the grass shoots of economic growth we have recently observed.

The RBA might want to one day get the cash rate to 3.5%, but at the moment the conditions for such a move look well off into the future.

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