The risks of The Great Unwinding and normalisation of interest rates

By definition, the global financial crisis and the great crash of 2009 were disorderly. Monetary authorities around the world deployed unprecedented measures to stimulate devastated economies, including cutting interest rates so far that they turned negative and injecting staggering amounts of liquidity through quantitative easing. Now, more than a decade after the crisis struck, the same authorities are beginning to unwind the stimulus. But will "The Great Unwinding" be orderly, or will it be disorderly, like the crisis it was designed to resolve?

Last week's stockmarket slump provides some early indications that the adjustment to normalised monetary policy settings might be rough. Putative signs of a pick-up in wages in the US – based on a single month's data – were enough to trigger a global stockmarket correction that appears far from over. Rising US bond yields sent a signal that inflation was reappearing, obliging the authorities to increase interest rates faster and by more than had been anticipated. US and European authorities are judging that keeping interest rates at emergency lows when the emergency has passed would invite a new bout of inflation.

But the gradual recovery from the crisis is not the only expected source of inflationary pressure. While conservatives are lauding the Trump tax cuts, last Friday's statement on monetary policy issued by the Reserve Bank suggests that market participants "expect that the US tax measures will stimulate demand more so than supply and hence add to inflation more so than to long-term growth". This is hardly a glowing endorsement of tax cuts that are unfunded to the tune of $US1500 billion ($1900 billion) over 10 years.

As US authorities hike interest rates to dampen inflationary pressures, commercial interest rates will rise in Australia regardless of the stance taken by our Reserve Bank. Australian banks continue to rely heavily on the wholesale funding market – overseas suppliers – for the money they lend to homebuyers and businesses. As the cost of wholesale funding rises the banks will pass on the extra costs to Australian borrowers.

The economic pain from rising borrowing costs will be compounded by the extremely high level of household debt in Australia, which has reached 200 per cent of disposable income – one of the highest in the world. To make matters much worse, one in four Australian mortgages and two out of every three property-investment loans are interest only. This is a ticking time bomb: monthly repayments will jump when the interest-only period expires.

As I have warned previously, Australia's economy might be a house of cards. While global interest rates remain at record lows, our economy will hold together, but when interest rates go up it could fall in a heap.

When mortgage holders and households investing in property are confronted by rising costs of their outstanding debt, they inevitably will pull back on spending on other items.

The other part of the explanation for weak retail spending is insipid wages growth. The federal government continues to assert that wage rises are just around the corner. Friday's statement on monetary policy casts doubt on wages rising strongly any time soon, pointing out, within its 76 references to wages, that new enterprise bargaining agreements are yielding low wage outcomes and, as old agreements expire, they will be replaced with new ones providing for lower wages growth.

Hopefully The Great Unwinding of monetary stimulus will not result in a crash in Australia. But nor will we be insulated from it. Nothing in recent Reserve Bank statements suggests it would contemplate cutting the cash rate here to offset the contractionary effects of rising global interest rates. In these circumstances, and in the absence of substantial wage rises, our debt-laden households will have to pull back on discretionary spending as they seek to service their more expensive loans.

If the stockmarket slump becomes a rout, they will cut their spending even further, as they watch their superannuation balances shrink. And remember, consumer spending is 56 per cent of our economy.