Worried about the mortgage cliff? This is what the Fed and RBA need to see before cutting rates

By design, high interest rates cause economic and financial hardship. When the cost of debt goes up, mortgage repayments increase, consumer spending falls, and companies make less investment.

Most of the time high rates are designed to cool an overheating economy. This time around, the enemy is high prices.

Yet today’s combination of high inflation and low growth has central banks walking a tightrope. They need to hit the brakes hard enough to shift the demand curve to the left and lower prices, but not so much that they precipitate a recession. 

Accurately predicting where rates will go is almost impossible to get right, but that doesn't diminish the need for investors to bake assumptions into their portfolios. You then tweak these assumptions as new information comes to hand.  

In this wire, I sketch out the current timeline for rate cuts by drawing on statements from the the RBA and Fed, and compliment that with the market's expectations. I then provide two simple checklists for the Fed and RBA to start cutting rates, provided by GSFM’s own economic guru Stephen Miller. 

What does the Fed say?

In December, the Federal Open Market Committee (FOMC) raised the federal funds target rate by 50 basis points to a range of between 4.25% and 4.50%.

The messaging was clear. Getting inflation down towards the 2% target remains priority #1. 

“No participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.”

They acknowledged that inflation pressures had “stepped down,” but stressed that “it would take substantially more evidence of progress to be confident that inflation was on a sustained downward path.”

What does the RBA say?

Things aren't looking too good in Australia after today's 7.8% headline inflation read. 

In December the RBA lifted the cash rate by 25 basis points to 3.10%. 

RBA Governor Philip Lowe stated at the time that the central bank was “resolute in its determination to return inflation to target and will do what is necessary to achieve that.”

Portending the pain still to come, he added that growth in 2023 will "be concentrated in weaker consumer spending and housing activity, against the backdrop of intensifying debt-servicing burdens and negative wealth effects from a 15 to 30 per cent peak-to-trough decline in house prices”.

Currently, the RBA is forecasting GDP growth at 1.4%, the unemployment rate at 1.37% and trimmed mean inflation at 3.80%. 

What do markets say?

Markets don't like monetary tightening. In fact they hate it. 

It's no surprise, then, that they are are striking an optimistic tone. According to CME Group, the market expects the Fed funds target range to top out at 4.75% to 5.00%, before falling to 4.50% to 4.75% in November.   

Australian cash rate futures, meanwhile, are pricing rates to top out at 3.57% in August before falling to 3.55% in November on the way to 3.30% in June next year.  

Fed checklist for cuts

The Fed has gone harder, sooner, in its fight against inflation," notes Miller. And that's moving the needle. US inflation was 6.5% over the year to December, down from 7.1% in November.

"There are some grounds for optimism in that regard," he says. 

"What that means is that the Fed's not going to keep going much beyond 5%, so I think they'll do 25 basis points to take the upper limit to 4.75%.

"The Fed is determined to keep the policy rate at around 5% for a longer period."

Miller believes the Fed would need to tick these four boxes in order to cut rates:

• Confidence that they can get Core Personal Consumption Expenditure (PCE) down to 2.5% by the end of 2023. (The current forecast is 3.1% in 2023.)
• Services inflation closer to the low 3% range. 
• A much sharper increase in the unemployment rate to something in the mid 4% in the next six months;
• A negative GDP read (rather than a 0.5% GDP growth over the year as they currently forecast). 

RBA checklist for cuts

As mentioned above, the inflation picture, while improving, is a long way from ideal. 

"It's turning, but it's turning from incredibly hot levels," says Miller. 

"It's not turning fast enough to mean that the RBA can pause; to be honest, they need to contemplate whether a 50 basis point hike is on the table. Because the inflation picture in Australia is now unambiguously worse than what it is in the US, the prospects for the RBA easing this year are even more remote."

Some of this is the RBA's own doing, says Miller. 

"The Fed's done the right thing in being aggressive towards the end of last year, whereas the RBA was cautious but has run the risk of letting the inflation genie out of the bottle, and that's shown up in these numbers," he says. 

"And if the genie does get out of the bottle, the costs in getting it back in are outsized compared to a more timely and early aggressive approach."

Miller's checklist for RBA cuts includes:

• GDP between 0% and 1%.
• Unemployment between 4.5% and 5%. 
• Trimmed mean inflation under 3.8%. 
• A housing market that has a material downward impact on activity growth and inflation. 
• Rising mortgage delinquencies. 

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