Australian homeowners face the steepest climb in mortgage rates in decades, but just how far interest rates will ultimately rise remains unclear.
What is certain is the Reserve Bank of Australia hasn't finished increasing the cash rate, after hiking it by 125 basis points since May.
While the cash rate is widely expected to surpass 2% by the end of the year and rise to at least 2.5% next year, economists' predictions for where and when it will peak vary greatly.
PropTrack senior economist Eleanor Creagh said the RBA is front-loading the tightening cycle, lifting rates more aggressively in a bid to rein in inflationary pressures.
Ms Creagh noted there is a wide forecast range for the peak in the cash rate, with financial markets and some forecasters expecting it to reach as high as 3.8%.
"There's a lot of uncertainty with respect to the terminal rate and how households react to rate rises will be critical," she said.
The RBA board made it clear there will be further rate hikes after increasing the cash rate by 50 basis points to 1.35% on Tuesday, the first time it has hiked rates by half a percentage point in two consecutive months.
![Brick veneer townhouses in suburban Melbourne](data:image/svg+xml,%3Csvg xmlns="http://www.w3.org/2000/svg" viewBox="0 0 800 450"%3E%3C/svg%3E)
More interest rate rises are on the way, but how fast and far the RBA increases the cash rate remains to be seen. Picture: Getty
Announcing the third rate hike in as many months, RBA governor Philip Lowe said the size and timing of future increases will be guided by incoming economic data and the board's assessment of the outlook for inflation and the labour market.
"The board expects to take further steps in the process of normalising monetary conditions in Australia over the months ahead," Mr Lowe said.
The RBA's 25 basis point rate increase in May and two hikes of 50 basis points in June and July represent the fastest tightening of rates since 1994.
More rate rises are on the way
Mr Lowe has emphasised that the RBA is not on a pre-set path in how fast and far it raises rates, but it is reasonable for the cash rate to get to 2.5% at some point, the midpoint of its inflation target range.
Two-thirds of the economists surveyed by comparison website Finder believe the cash rate will peak at 2.5% or higher.
The Conversation's forecasting survey predicts the cash rate will peak at 3.1% by next August, although some economists expect even steeper increases.
Economists' predictions for the peak in the cash rate vary widely. Picture: Getty
Three of the four major banks predict the RBA will deliver a third consecutive hike of 50 basis points in August following the release of the latest quarterly inflation data. Commonwealth Bank of Australia economists at this stage marginally favour a standard rise of 25 basis points.
CBA, Australia's biggest lender, expects the cash rate to reach 2.1% by the end of 2022, although a 50 basis point hike next month would take it to 2.35%.
"Financial conditions will continue to tighten over 2023 with no change in the cash rate given the big fixed rate home loan expiry schedule, and we have 50 basis points of rate cuts in our profile for the cash rate for late 2023," CBA head of Australian economics Gareth Aird said.
With the RBA expecting inflation to peak at around 7% later this year before declining back towards its 2% to 3% target range in 2023, Mr Aird said the board will not simply continue to use the rate hike lever indefinitely to run hard against higher near-term inflation data.
"The RBA is not on a crusade to hasten a drop in the rate of inflation at all costs. Other central banks appear more impatient," Mr Aird said.
The RBA is hiking rates more aggressively in a bid to tame inflation. Picture: Getty
AMP chief economist Shane Oliver said the RBA will probably hike again by 50 basis points in August, but thereafter make more gradual moves as economic data slows, with the cash rate to reach 2.1% by the end of 2022.
"We expect the cash rate to peak around 2.5% in the first half of next year as the economy slows faster than the RBA is assuming which will take pressure off inflation," Dr Oliver said. "Rate cuts are expected in the second half of 2023."
Dr Oliver does not believe the cash rate will need to go as high as the money market's expectations of 3.7% over the next 12 months.
"The RBA just wants to slow things down to take pressure off inflation and give time for supply to catch up," he said.
"It does not want to crash the economy and is not on autopilot. So, it will be watching indicators of spending and things like house prices very closely."
Westpac chief economist Bill Evans expects the terminal rate will be 2.6%, with the last hike of 25 basis points in February 2023. That would represent a cumulative increase in the cash rate of 250 basis points over nine RBA board meetings.
Mr Evans noted that would be the second fastest tightening cycle since the RBA began announcing its desired level for the cash rate in January 1990, exceeded only by the 275 basis points increase over five meetings in the second half of 1994.
ANZ economists see the cash rate at 2.35% at year-end and hitting 2.6% in February, when it expects the RBA will pause for a period due to weak global growth and signs that labour demand in the Australian economy is easing.
"But with inflation expected by the market to be more persistent than the RBA expects, we see rate hikes resuming late in 2023 and the cash rate getting to 3.1% by early 2024," ANZ head of Australian economics David Plank said.
How households react to rate hikes will be key
There is still a lot of uncertainty about how quickly inflation pressures cool and how high rates go, Ms Creagh said, adding that the growing pressure on household budgets has already dented consumer confidence.
"The cost of living has risen and real wages growth remains negative at present, with higher interest payments dampening household incomes," she said.
"You've also got higher fuel prices, electricity, gas, rental price pressures, higher food prices and mortgage repayments rising as well."
Ms Creagh said how the dynamic of a tight labour market and financial buffers built up by households plays out against the backdrop of an aggressive rate hiking cycle will be crucial in determining the impact on the economy and ultimately the terminal cash rate.
"This is a rapid policy tightening and whilst high household debt and weak sentiment is a risk, these factors are offset by the tight labour market promoting a degree of confidence and job security and hopefully in turn stronger wages growth.
"In addition, households are sitting on large savings buffers, for many substantial home equity has been accumulated after the significant rise in home prices over the last two years, and many have taken advantage of falling interest rates to pay down debt quicker.
"The RBA estimates the typical owner-occupier borrower is around two years ahead on their mortgage."
Mortgage rates are increasing from their record low levels during the pandemic, at the same time as the cost of living rises sharply. Picture: Getty
Ms Creagh expects the cash rate to reach just above 2% by December, with the potential then for a pause.
She did not offer a forecast the cash rate peak, noting conditions could change quite quickly as rates rise and households tighten up discretionary spending.
"We expect further declines in housing values and that negative wealth effect as the value of what is most people's largest asset declines typically weighs on consumption and spending.
"So, certainly if the cash rate ends the year around 2% or above I would expect that by next year we will potentially be seeing GDP [gross domestic product] and consumption forecasts downgraded and the potential for rate cuts in the second half of 2023 if unemployment were to tick up again."
The RBA will be paying close attention to household spending as it makes decisions on interest rates. Picture: Eugene Hyland
Mr Lowe said the RBA board will be closely watching household spending.
He said recent spending data has been positive, although household budgets are under pressure from higher prices and rising rates, adding many households have built up large financial buffers and are benefiting from stronger income growth.
Mr Aird said the RBA appears less certain as to how savings buffers will impact consumer spending from here.
"Whilst these buffers are positive from a financial stability perspective, households are unlikely to use money sitting in offset accounts to fund discretionary expenditure in an environment of sharply rising interest rates and falling home prices," Mr Aird said.
Dr Oliver said the build up in excess household saving of about $250 billion through the pandemic imparts a degree of resilience for households, and high debt levels mean the RBA won't need to raise rates as much as in the past to control inflation or as much as the money market expects.
While many households build up large financial buffers during the pandemic, they still face "pain" from higher mortgage rates as the cost of living rises. Picture: Eugene Hyland
Dr Oliver said many households will experience a significant amount of pain from higher rates.
He noted that a new borrower with an average $600,000 mortgage will have seen their monthly repayments rise by about $420 a month since April once the latest rate hike is passed through - nearly $5100 extra a year.
"Taking the cash rate to 3% would imply an extra $12,200 a year since April in mortgage payments. That is a huge hit to the household budget."
Falling home prices are another factor
The rapid rate rises have already slowed home price growth Australia-wide, with the latest PropTrack Home Price Index showing prices fell in Sydney, Melbourne, Brisbane and Canberra in June.
Ms Creagh said PropTrack expects home prices to fall by 10% to 15% nationally over the next 18 months, with Sydney and Melbourne recording larger price falls.
"We are looking at a further downturn in home prices in the period ahead, with price falls also becoming more widespread."
Home prices are expected to fall over the next 18 months, but it comes after a period of extraordinary price growth during the pandemic. Picture: Getty
Ms Creagh said it was important to put the widely-expected price falls into context.
"We have seen extraordinary growth in housing prices over the last two years, with home prices up 34% on pre-pandemic levels," she said.
"We're seeing potential buyer demand easing as mortgages become more expensive and borrowing capacity is further constrained.
"But even if prices fall 10 to 15% they would still be higher than they were at the start of the pandemic."
Dr Oliver said just as the cut in interest rates to record lows was the key driver of the recent price boom, the surge in mortgage rates now underway will be the main driver of the property market ahead.
He noted fixed mortgage rates are now up two- or three-fold from record lows around 2% early last year and variable rates are rising rapidly, substantially reducing the amount new homebuyers can borrow.
Record-low interest rates were a key driver of the price boom during the pandemic and mortgage rate hikes will be the main driver of the property market over coming months. Picture: Getty
After lifting its peak rate forecast to 2.5%, AMP now expects national average property prices to record a larger top-to-bottom fall of 15% to 20% over the next 18 months.
"Falling home prices and other signs of weakening consumer demand will ultimately help limit how much the RBA will have to raise the cash rate by," Dr Oliver said.
CBA expects home prices nationally will fall by about 15% over the next 18 months, which Mr Aird also believes will influence the RBA's thinking.
"The impact on falling home prices on the economy will intensify and exponentially rise the further dwelling prices fall. In turn we believe that will ultimately act as a limit to how high the RBA will be willing to take the cash rate."
Mr Aird said there remains a risk of 'over tightening', noting the Australian household sector is more sensitive to changes in interest rates than at any other time because the level of household debt to income sits at a record high.