While placing the likelihood of a US recession at 75 per cent, Konark Saxena, an associate professor at the UNSW Business School, said that high interest rates in the US pose a higher risk to Australia than its economic slowdown.
Namely, according to the associate professor, the real economy should remain resilient to a potential US recession if “we are able to avoid financial distress” that, he said, will likely befall countries unable to match the high US interest rates.
“High US interest rates will put pressure on countries to either increase domestic interest rates or accept a substantially devalued currency because capital chases currencies with relatively higher interest rates,” associate professor Saxena said.
“This outflow of capital from lower interest rate countries might push some highly leveraged economies into financial distress, especially those with USD denominated debt.”
Regarding Australia, the associate professor said there are two types of financial distress risks he is particularly concerned about — household financial distress and currency risk.
“Household financial distress increases if households can’t pay their mortgages when the RBA [Reserve Bank of Australia] increases interest rates too much. Currency crisis risk increases if capital leaves Australia for higher interest rate currencies when the RBA does not increase interest rates enough,” associate professor Saxena said.
“It is a delicate situation and there is a risk that eventually, RBA will not have enough flexibility to manage these two conflicting forces,” he warned.
One way to avoid these two extreme scenarios, he said, is by increasing labour productivity, wage growth, and wage inflation.
“If households are working and their wages are growing enough, they should be able to handle increases in interest rates thanks to their higher pay cheques. Such wage inflation can help not only working home owners pay higher nominal interest rates, but it also benefits renters who can save more,” associate professor Saxena said.
“If we can manage an orderly reduction of (nominal) household debt without incentivising too much risk-taking, then it will give RBA more flexibility to increase interest rates and bring them in line with US interest rates.”
The RBA is expected to hike rates again at today’s board meeting and, following the higher-than-predicted increase in the consumer price index (CPI), some are proposing that another supersize 50 basis point hike is warranted.
