Is inflation holding home owners to ransom?

Since mid-2021, inflation – as measured by the Consumer Price Index (CPI), has jumped from around 2.1% to a whopping 7.4% today. It’s the highest rate of inflation seen in decades. For you and I it means paying more for pretty much everything. And it has central bankers worried.

High inflation isn't just bad for our hip pockets, it can cause serious damage to the economy. It also poses a threat to investors as inflation chips away at “real” (after-inflation) returns.

We’re already seeing this with returns on savings accounts. Even though it’s now possible to earn 4% or above on at-call savings, the purchasing power of those savings is falling by 7.4% annually thanks to inflation.

This explains why the Reserve Bank is so determined to push inflation down to its preferred level of 2-3%. That's the sweet spot that lets consumers and businesses keep spending and saving while prices rise modestly. It's also a level of inflation that other countries (including Australia) have achieved in the past with positive economic outcomes.

When it comes to keeping inflation in check, the Reserve Bank’s chief tool is the official cash rate. That's the interest rate banks pay when they borrow money from each other overnight to meet their daily cash needs, and when banks have to pay a higher rate, they pass the extra cost straight onto variable rate home loan borrowers.

That's exactly what the Reserve Bank wants to happen.

The idea is that by raising rates, the nation’s one-in-three home owners with a mortgage have to make bigger loan repayments each month. This leaves less money to spend on other things. So businesses have to lower prices to make their products more attractive to shoppers, which pushes inflation down, breaking the cycle of rising prices.

To date, the Reserve Bank has jacked up the cash rate from 0.1% to 3.6% since May last year.  That’s putting tremendous pressure on anyone with a variable rate home loan. Canstar modelling shows that repayments on a $500,000 loan have risen by around $1,084 per month since April 2022. Anyone with a $1 million mortgage is having to find an extra $2,168 each month.

Finding this extra cash is no easy task, and it can seem as though home owners are doing the heavy lifting when it comes to bringing down inflation. There’s a certain amount of truth to this. Unlike fiscal policy, the Reserve Bank’s monetary policy efforts can be very quick to implement, and to take effect. That’s part of its appeal, and it seems to be working.  The latest CommBank Household Spending Intentions Index[1] shows a decline in consumer spending, especially discretionary spending such as entertainment, retail, and travel, as consecutive interest rate hikes bite into household budgets.

The catch is that rising rates hit households with a  home loan hardest. The Reserve Bank has acknowledged that higher rates are putting an extra burden on mortgage holders. Even so, Christopher Kent, Assistant Governor (Financial Markets) at the Reserve, recently repeated the central bank’s mantra that this burden “will be higher still if we don’t bring inflation down in a timely manner”[2].

To be fair, the Reserve is facing a challenging set of conditions with plenty of variables at, or near, record levels.  Inflation is at a 30-year high. Unemployment is at a 50-year low, and high levels of household savings through the pandemic mean interest payments as a share of household income will soon be at a record high[3].

The upshot is that we may not have seen the last of rate hikes. It’s possible that the Reserve Bank may pause rates in April but this all hinges on the latest inflation data and the global economic outlook.

What’s interesting, is that despite cost of living pressures, deposits in savings accounts grew by $32.3 billion in the final quarter of 2023. The Australian Bureau of Statistics[4] says there is now a record $623.3 billion invested in savings accounts and fixed-term deposits.

Of course, you'd expect that when home loan rates go up, we'd also earn more on savings accounts. But that's not happening across the board.

Plenty of banks have only lifted rates on some – not all – savings accounts, and not always by the same uptick in mortgage rates. The highest rates are generally reserved for promotional and or bonus offers. This hasn’t escaped the notice of consumer watchdog, the ACCC, which recently announced an investigation into how banks set their rates on deposit accounts.

With a Federal Budget due in May, we could see more being done to tame rising prices. In the meantime, it's up to each of us to beat inflation at the frontline by shopping around and comparing prices to get the best possible deal on everything – from groceries to home loans and savings accounts.