A dozen rate hikes felt a dozen different ways

In brief

• Higher interest rates are designed to make consumers think twice about spending and it is likely that we will see the slowdown in Australia’s household consumption intensify as the year continues.
• The slowdown so far has been muted by the strong labour market, savings buffers and fixed low-rate mortgages protecting consumers’ balance sheets from rising interest rates.
• To determine which goods and services are likely to be put at the bottom of consumers’ shopping lists, EY analysed the impact of interest rates on different segments of consumer spending. Spending on cigarettes and tobacco, communications, food and furnishings are most sensitive to fluctuations in interest rates. Conversely, transport services, utilities, operation of vehicles, and hotels and restaurants were found to be the least affected.
• Firms operating in discretionary or non-essential goods and services industries should brace for slower consumer spending ahead.

Resilient household consumption amidst a strong recovery from the pandemic

The Australian economy rebounded strongly from the impacts of the pandemic and associated lockdowns, supported by household consumption.
Households spent up on discretionary or non-essential goods during lockdowns and restrictions, given boosted income from fiscal stimulus and low interest rates while services consumption, such as travel and recreation, was restricted. When restrictions eased and borders reopened, services were in high demand. Household consumption growth rose above trend rates even when accounting for rising prices.

Household consumption started to moderate in the December quarter of 2022, showing annual growth of 5.4 per cent, down from 11 per cent in the previous quarter. Consumption slowed down further in the March quarter, with annual growth reaching 3.5 per cent and consumption rising just 0.2 per cent through the quarter, the weakest result since the pandemic. Growth in non-essential spending weakened to be more in line with essential spending. However, non-essential spending switched from goods to services such as travel and hotels, cafes and restaurants.

The slowdown in household consumption growth that began late in 2022 is expected to persist as higher interest rates and cost of living pressures continue to put pressure on household budgets. As the economy slows and unemployment rises, further cautious spending by consumers is likely. The Reserve Bank of Australia forecasts annual growth in household consumption to slow to 1.3 per cent by the end of this year, before picking up again to reach 2.4 per cent by mid-2025.

The Reserve Bank attempts to pour water on the inflation fire

The better-than-expected pandemic recovery – assisted by fiscal and monetary stimulus – combined with supply constraints caused by COVID-19 and the war in Ukraine drove prices higher, broadly across the economy. Inflation rose to just under 8 per cent in annual terms at the end of December 2022. It fell to 7 per cent in March this year and monthly inflation data suggests inflation has moderated further to 5.6 per cent in May. But inflation, including core measures, remains far above the Reserve Bank’s inflation target band of 2-3 per cent.

Prices for both goods and services rose considerably. High inflation inflicted both non-essential and essential goods and services. This high and persistent inflation forced the Reserve Bank to hike the cash rate quickly. So far there have been 12 rate rises since May 2022, taking the cash rate 400 basis points higher to 4.1 per cent.

The Reserve Bank’s goal is to bring inflation back to the 2-3 per cent target band, to prevent inflation from eroding the purchasing power of income and savings. When the economy grows too quickly, the Reserve Bank increases interest rates, or the price of money, to dampen economic activity and contain inflation. Access to credit becomes more expensive and tighter, which reduces consumption and investment, and increases saving. This reduces aggregate demand and puts downward pressure on employment, which helps contain wage pressures. Firms then adjust their prices and inflation falls.

The Reserve Bank is keen to ensure that inflationary expectations – what households and businesses believe inflation will be in the future – do not become unanchored from the target band, as this is an important determinant of realised, or actual, inflation. If consumers and businesses believe that the Reserve Bank cannot successfully bring inflation back into the target band, they factor these higher price expectations into their spending and wage negotiations. This is known as a wage-price spiral.

Impacts of rate hikes on consumer spending patterns

Changes in interest rates impact household spending by affecting interest income and payments, and consequently the amount of cash that households have available to spend. Changes to household cash flows are an important channel of monetary policy (otherwise known as the cash flow channel).

The wealth channel, where interest rates can impact asset prices, can also impact household spending. As interest rates rise, asset prices (including house prices) fall and households feel less wealthy, discouraging them to spend.

The following graph measures household consumption in real terms (adjusting for inflation) and is also detrended (which indicates the per cent deviation from its trend). Negative values indicate below-trend household consumption, while positive values indicate consumption patterns above-trend. The shaded areas indicate tightening cycles that have been undertaken by the Reserve Bank since inflation targeting began in the early 1990s. There have been six of these and in each, prior to the most recent, household consumption has slowed or fallen below trend following tightening. In the most recent case, despite the most aggressive rate hiking cycle (12 rises and 400bps), household consumption has so far remained slightly above trend after rising significantly above trend – although the full impact of the cash hikes has not yet fully impacted households.

The ongoing strength of household spending in recent months is most likely linked to several factors.

First, the very strong labour market conditions which have seen more Australians than ever gain employment. Second, the build-up in savings during the pandemic, when households were unable to spend on their typical goods and services. Third, high household wealth which, despite falling in the second half of 2022 and into 2023, remains well above pandemic levels mainly due to very strong rises in house prices during lockdowns. And finally, the high proportion of mortgage holders with low fixed-rates– some locked in as low as 2 per cent for several years. About 50 per cent of all fixed-rate loans are reaching the end of their terms over the coming year meaning low rates become considerably higher. However, it is likely that some households have already started adjusting their consumption accordingly putting money aside in preparation, which could be linked to savings remaining relatively elevated.

There could also be an element of ‘revenge spending’, where consumers are making up for lost purchases during lockdowns, especially related to travel and hospitality.

The reluctance to reduce spending conflicts with consumer sentiment, which has fallen to recessionary levels, according to the ANZ Roy Morgan survey data. A further analysis of the sub-indexes of consumer sentiment reveals that the strength in consumption comes despite the ‘Time to buy a major household item’ remaining below its long-run average level throughout the past few years.

More recently, this measure has fallen to the lowest levels since the start of the pandemic. Consumers’ views on future financial and economic conditions (over the next 12 months) also fell far below their long-run averages from early 2022.

Which areas of consumption are impacted by higher interest rates first?

Through regression analysis, EY undertook a deep dive into the impacts of interest rates on different segments of consumer spending to help our clients understand which areas of consumption would be impacted most significantly by tightening monetary policy.

Our analysis reveals that consumer spending on cigarettes and tobacco, communications, food and furnishings are found to be the most sensitive to fluctuations in interest rates. Conversely, the purchase of transport services, utilities, the operation of vehicles and hotels, cafes and restaurants are the least affected by changes in interest rates.

Our regression model utilised the Reserve Bank’s cash rate and consumer expenditure for 18 different spending categories (in real terms, adjusted for inflation) collected quarterly from September 1991 to March 2023. As a robustness check, we did the same analysis but excluded the COVID-19 period to provide non-pandemic responses to changes in the cash rate which delivered slightly different results as discussed below.

Our model incorporated a 12-month lag on the cash rate which was implemented as an independent variable. The inclusion of the lagged variable was based on existing research indicating that monetary policy has a delayed impact on consumer behaviour, as it typically takes 12-18 months for monetary policy changes to flow though and impact the economy.

By conducting a regression analysis, we examined the influence of changes in the cash rate on the different categories of consumer expenditure with the goal of determining the sensitivity of the expenditure categories. The spending categories were then ranked based on their coefficient of determination (so-called r-squared), which indicates the proportion of variance in consumption behaviour explained by changes in the cash rate. Higher r-squared values reflect greater sensitivity to changes in the cash rate (ranging from 0 to 1).

We ranked the consumption categories from most to least sensitive based on our findings, as follows:

Cigarettes and tobacco are the spending category most impacted by interest rate movements. The model shows that 80 per cent of changes in this spending category could be explained by changes in the Reserve Bank’s cash rate one year earlier. This result might not be clear-cut given the addictive nature of cigarettes and tobacco. However, this is probably due to the fact that people in lower socio-economic groups are more likely to smoke, and those groups are more sensitive to interest rate movements. Our model suggests this category could see one of the stronger slowdowns going forward. Consumption of cigarettes and tobacco has already fallen 8.7 per cent through the year to March. However, this would be partly driven by a general downward trend in cigarettes and tobacco consumption, reflecting significant price increases due to taxes and duties associated with health-related policies.

Expenditure related to communications, such as mobile phones, laptops, and internet bills, have also shown to be highly sensitive to cash rate movements in the past. If a recession looms, consumers may reconsider buying the latest technology and or delaying purchases. Equally, when interest rates are being cut, this is where they would adjust their spending patterns quickly. Consumption in this spending category has not yet seen a fall.

The high sensitivity of food expenditure is surprising given most consumers would consider the weekly food shop essential. However, consumers can decrease their spending in this area by substituting goods such as fresh and exclusive labels for home-brand items and frozen goods. Food consumption has fluctuated since the rate hiking cycle began but there has not been a downward trend yet.

It’s not surprising that furnishing and household goods are amongst the most sensitive goods and services to interest rate changes given a significant portion of spending on these items is from new home buyers or new renters looking to furnish their home. It’s also easier for households to spend on secondhand goods via online marketplaces or simply just choose to defer their purchases of decorative items. Consumption of furnishing and household goods has fallen 6.5 per cent in annual terms since its peak in the March quarter last year.

Transport services are the least sensitive category of spending to interest rate movements. Only 12 per cent of movements in this spending category can be explained by changes in the cash rate. When transport services are used for commuting to workplaces, it is hard to adjust spending patterns. On top of this, there might be a substitution effect with households switching from driving their cars to using public transport. For those workers who are able to work from home more frequently, particularly when the cost of travelling to work is high, this could alter the responsiveness of this consumption category. Passenger air travel for both domestic and international, as well as passenger travel by sea are included in this category. The unresponsiveness in this subcategory would be driven by the pandemic period – during lockdowns people did not travel despite lower rates and now people travel despite higher rates due to revenge spending on travel.

When excluding the pandemic period, transport services are still the least sensitive category, but 45 per cent of movements can be explained by changes in the cash rate rather than only 12 per cent.

Spending on utilities such as electricity and gas is also less sensitive to interest rate changes as they are essential goods which are difficult to reduce substantially.

Expenditures related to the operation of vehicles, such as repairs and maintenance, are also less sensitive, again because they are essential services.
Hotels, cafes and restaurants are also amongst the least sensitive spending categories. This is again driven by the pandemic period as people were not able to consume those services during lockdowns when interest rates were low and are now consuming them despite high rates. When excluding the pandemic period, hotels, cafes and restaurants become one of the most sensitive categories, suggesting this category has shown some unusual demand, particularly because of the way the pandemic impacted consumption choices.

The results line up with EY’s most recent Future Consumer Index for May, with 52 per cent of consumers surveyed strongly agreeing that high interest rates and the cost of living is impacting their ability to afford non-essential items such as entertainment, fashion and homewares. Just under 50 per cent (46 per cent) of consumers strongly agreed that these factors are impacting their ability to afford essential items such as food and healthcare. More concerning is that 34 per cent of surveyed consumers strongly agreed that they were finding it difficult to meet their mortgage repayments.

When asked about spending intent in the next four months, over 60 per cent of surveyed consumers noted that they would spend less on ‘luxury items and other indulgences.’ This was followed closely by ‘other big ticket items’ and ‘takeout/delivery meals’. Fewer consumers, 16 per cent, intended to spend less on food (canned, frozen and fresh), followed closely by household products (cleaning) and personal care items. This is likely due to their essential nature.