Australia's central bank sees growing risks to financial stability

The Reserve Bank of Australia (RBA) said financial stability risks have risen in recent months, with some households and businesses already facing "tougher conditions" as interest rates rise and inflation accelerates.

"Household income growth has not kept pace with inflation," the RBA said in its semiannual financial stability survey released Friday in Sydney. "This has resulted in households having less ability to cover their rising housing costs -- loan payments or rents -- while maintaining their consumption and savings levels."

The RBA said it will closely monitor key indicators of financial stress as risks to some vulnerable households increase, while acknowledging that balance sheets are generally in "strong shape."

The RBA is in the midst of its most aggressive policy tightening in a generation, having increased its key rate by 2.5% since May. RBA Chairman Philip Lowe signaled the need for further rate hikes in the fight against inflation, even as he surprised markets by moving to a lower pace of hikes this week.

The RBA's tightening has already led to a slump in the real estate market, with prices in Sydney falling for the eighth straight month in September. Economists are predicting that the RBA interest rate will peak at about 3.2% from 2.6% currently, while money market pricing is somewhat more aggressive and suggests a peak rate of 3.6%.

Nevertheless, RBA modeling shows that the share of households at high risk of default is likely to remain low in coming years, based on its core scenario of job and income growth. However, if economic conditions deteriorate, "a large proportion of households are expected to incur mortgage debt," he warned.

Modeling shows that if interest rates rise to 3.6 percent, as the markets suggest, just over half of floating-rate borrowers will see their free cash flow shrink by more than 20 percent over the next few years. About 15% of households will see their free cash flow turn negative.

Most Australian mortgages are at variable rates, only about 35% are on fixed-rate terms, about two-thirds of which will expire by the end of 2023.

RBA analysis shows that most of these fixed-rate borrowers will face a 3-4% increase in borrowing costs when they switch to floating rates based on current market prices.