The RBA has finally applied the brake to interest rate hikes, but it may only be a time-out to gather breath, considering market vulnerabilities and widespread credit risk, writes AICD chief economist Mark Thirlwell MAICD. 

    The Reserve Bank started hiking the cash rate target in May 2022. Ten consecutive increases and a cumulative 350bp of monetary policy tightening later, it hit pause at its April 2023 meeting.

    Strikingly, although Martin Place had flagged the possibility of an Easter break at the previous monetary policy meeting, before that it had been signalling the likelihood of multiple rate increases as recently as its February 2023 meeting, telling us that “further increases in interest rates are likely to be needed over the months ahead”. Yet it took just one more 25bp increase in the cash rate target, on 8 March, before the RBA decided to hold fire. That volte-face largely reflected developments on the domestic data front, plus concerns over economic uncertainty and the lagged impact of previous rate hikes. But it also followed several weeks of turmoil in US and Swiss banking markets, including the biggest US banking sector failure since the global financial crisis.

    In the weeks preceding April’s meeting, the RBA had indicated that future rate decisions were increasingly data-dependent, driven by a range of indicators including trends in household spending, developments in business conditions, the degree of labour market tightness and measures of inflationary pressures including wage- and price-setting behaviour. From that list, several factors appear to have been particularly important in driving the April decision.

    Firstly, while the monthly CPI indicator has its limitations, the latest readings suggested that inflation had peaked at the end of 2022, with the annual rate of inflation easing from 8.4 per cent in December 2022 to 7.4 per cent in January this year, and then to 6.8 per cent in February. Meanwhile, although the pace of wage growth had continued to accelerate (to an annual rate of 3.3 per cent in Q4:22), it remained consistent with the inflation target. Similarly, the RBA did not see any compelling evidence of economy-wide, profit- driven inflation. Finally, the combination of higher interest rates and increases in living costs meant that the pace of consumption growth had slowed significantly from the rapid catch-up that had followed the exit from COVID-19 lockdowns.

    However, while sufficient to persuade the RBA to pause its campaign of rate increases, this was not enough to convince the central banker that its job was done. It retained a tightening bias after the April meeting, saying it expected “some further tightening of monetary policy may well be needed to return inflation to target within a reasonable time frame”.

    International unease

    Importantly, it was not just domestic events shaping the policy environment in March–April. Policymakers also had to contend with what the RBA’s latest Financial Stability Review (FSR) calls “the most severe banking system stress event since the global financial crisis”. This “event” comprised the failure of three regional US banks — Silvergate Bank, Silicon Valley Bank (SVB) and Signature Bank — followed by the regulator-led takeover of Switzerland’s Credit Suisse by UBS.

    This mini banking crisis in the US was a product of concentrated and mostly uninsured deposit bases, poor risk management, inadequate supervisory oversight and the devastating impact of higher interest rates on large, unhedged holdings of long-term, fixed- rate debt securities. The subsequent rise in global financial stress and liquidity strains then forced the Swiss National Bank (SNB) to extend more than US$50b in emergency liquidity support to Credit Suisse before local regulators intervened to force a UBS takeover.

    At the time of writing, that bout of global banking distress looked to have been contained, with the US Federal Reserve, the European Central Bank and the SNB all feeling comfortable enough to deliver March rate hikes. Direct implications for the Australian banking system also proved limited. As the RBA explains in its latest FSR, Australian banks have strong capital and liquidity positions with key ratios comfortably above the relevant regulatory requirements. And in several key areas, the Australian Prudential Regulation Authority’s prudential framework is super-equivalent to global regulatory standards. Australian banks are also relatively less exposed to interest rate risk than were the failed US institutions, as they have smaller holdings of financial securities, shorter duration portfolios and greater natural hedging in the form of variable rate mortgage assets. Australian banks are also required to carry capital to address the risk of rising interest rates as part of their core capital requirements — so as interest rates rise and financial asset values fall, they must hold additional capital.

    Higher rates, higher risks

    Nevertheless, the March banking shock serves as a powerful reminder that the current era of higher global interest rates is also an era of increased financial risks. Big losses on fixed- income portfolios have been widespread this year and go well beyond SVB and its ill-fated peers. The combination of higher interest rates and higher inflation is pushing up credit risk across corporate and household borrowers. Regulators are worried about the health of the global commercial real estate market, where the pressure from higher interest rates is magnifying structural challenges arising from the shifts to working from home and online retail. And both financial regulators and leading institutions including the International Monetary Fund (IMF) have highlighted ongoing risks to non-bank financial intermediaries (NBFIs) including asset managers, insurance companies, pension funds, commodity traders and hedge funds. This so-called “shadow banking” sector has vulnerabilities powered by leverage and liquidity, with the IMF listing liquidity mismatches (some NBFIs hold relatively illiquid assets, but allow the investor to redeem shares on a daily basis), liquidity spirals (whereby a fall in asset prices leads to a decline in funding liquidity, which then leads to further market falls) and crowded trades (as a growing similarity in portfolios increases the risk of correlated shocks). High-profile examples include UK pension fund stress in October 2022 following the “Trussonomics” budget debacle, and the strains on some commodity trading firms at the time of the nickel market suspension at the London Metal Exchange in March 2022.

    Not only must central banks pay close attention to inflation and growth developments in the real economy, but they also need to worry about financial conditions, both at home and in global markets. Perhaps it’s no surprise then, that the RBA felt that an April pause to better gauge the economic and financial temperature was warranted.

    This article first appeared under the headline 'Sigh Of Relief' in the May 2023 issue of Company Director magazine.  

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