Have you heard recent rumours of rising interest rates? In this week’s Bush Bite, I’d like to spend some time ‘balancing the books’ and explore if and when rates will rise and what it means to you…
The honeymoon period of record low interest rates is coming to an end, with more than half of economists predicting interest rates are going to rise this year. Really?
This is just one of a bunch of scare mongering media headlines that has occupied our eyes and ears over the last few weeks. So-called self-proclaimed experts have been grabbing headlines with stories of gloom and doom on the interest rate front following concerns over increases, inflation and the ending of quantitative easing through bond-buying, which is really just code for ‘printing more money.’ Unfortunately, I think the only thing that’s overinflated are the media’s egos and interest rate claims. It feels like with every new year, there’s a new fear to keep us both nervous and anxious. The last two years have been Fear Factory Paradise, with the endless COVID variants providing never ending fuel for the far reaching fear-fire. And now that the pandemic appears to be almost under control as we’ve almost run out of variant names in the Greek alphabet, the next thing to keep us all nervous is to focus our fear on interest rate rises and potential crashing property prices.
Unfortunately, most predictions and forecasts revolve around the so-called science of explaining tomorrow why the predictions made yesterday didn’t come true today. So, I want to balance the books by having a look at what’s really likely to happen with interest rates this year, what impact it will have on you, and what, if anything, you will need to do or to think about. So are interest rates likely to rise? Well, the answer is yes. Unfortunately, it’s not a matter of if, but the real questions are around when, and by how much, and how often.
Let’s start by looking at the worst, best and likely scenarios. The worst case being reported by some self-proclaimed media gurus and has been actually priced in by futures markets, is that rates will rise by that one per cent by the end of the year, with the first increase in the cash rate from 0.1% to 0.25% occurring as early as May and then rising by monthly over the course of the year, up to 1% or more. Now, remember that the cash rate is generally roughly two and a half per cent below actual home run rates, so this is going to mean that an increase in average variable home loan rates will go up from about 2.5%, up to about 3.5% over the course of the year, which doesn’t actually sound like much over the course of interest when you look at things in history.
Now the best case, on the other hand, is that the Reserve Bank governor will stick to his guns. When he repeated that over the last couple of years since the start of the climate crisis, in his forward guidance, the rates are going to remain on hold until 2024, at least. Now, the likely case is probably going to be somewhere in between, in my humble opinion. Rates are going to remain where they are until at least late this year and will only then rise marginally and slowly, depending on the impact of a bunch of economic variables and uncertainties. Now what’s this based on? It’s not based on gut feel, reading the tea leaves or trying to be a sensationalist headline hero, but actually listening to recent real comments by the person who’s actually in charge of making cash rate decisions. And that’s the Reserve Bank Governor Philip Lowe. Having listened in full to his year ahead speech that he made on the 2nd of February, he made it very clear that the Reserve Bank is in no hurry to increase interest rates.
So let me share with you his key statements that helped me draw this conclusion. Government alone started with shared optimism when he said that our economy has weathered the pandemic much better than was expected. Job growth is strong and unemployment is low. Household and business balance sheets are generally in good shape and wages growth is picking up. Now these are very positive and welcome developments, but here’s his scene-setter where he said “at the same time, though the country faces challenges, the pandemic is not yet behind us, and the sharp pick up in inflation in some parts of the world, particularly in the United States, has added a new element of uncertainty to the outlook.” He then goes on to talk about our continued recovery, where he said that while Omicron has delayed the recovery of the Australian economy, it hasn’t derailed it. That recovery is being underpinned by a number of factors. These include household balance sheets that are generally in good shape, with households having accumulated more than $200 billion in additional savings over the past two years. And according to other data, the average homeowner is about 45 months ahead in terms of their repayments. So pretty good situation now. Governor Lowe went on to say that an upswing in business investment is also underway, and there’s a large pipeline of residential building to be completed over the next year or so. Macroeconomic policy settings are also supportive of both, with governments planning significant infrastructure spending and monetary policy is very accommodative. Australia hasn’t experienced unemployment rates this low in the past half century, and the last time we had the unemployment rate below four per cent was way back in the early 1970s. Now, all of this is very positive news.
Let’s now turn to the subject of inflation or rising prices, which is sparking the media’s negative pessimism on interest rates. Because the RBA governor said that the pick up in inflation reflects both the strength of the economy, the strength of the economic recovery and is the real crux of the matter. The significant disruptions on the supply side now, as we all know from our high school economics, the cost of anything or the value of anything is the balance between supply and demand. And over the last two years, we’ve seen a massive increase in demand from all of the stimulation money that’s being poured into the system. While world supply has been strangled until dribble due to COVID transportation restrictions and slowdowns now, Governor Lowe then went on to say that headline inflation in particular, has been boosted by the 32% increase in petrol prices over the past year, along with the 7.5% increase in the cost of constructing new homes. Looking ahead, we expect underlying inflation to increase further over coming quarters, largely reflecting the ongoing difficulties on the supply side. And again, here’s the kicker, when he said “as these problems are resolved, some moderation in inflation is expected.” Now, this suggests that the current kick in inflation is only temporary. As a result of abnormal supply and demand conditions created by the global pandemic, he then expands on this further when he said on the inflation and wages fronts, there are also a range of significant uncertainties. There’s that word uncertainty, again. These partly stemmed from the uniqueness of the period in which we’re living. Over the past two years, there’s been very strong demand for the goods, probably just at the time that the ability of the economic system to produce and distribute goods has been impaired.
In other words, what he’s saying here is that there is a significant temporary demand with limited ability to supply. Governor Lowe then went on to say that this strong demand colliding with the impaired supply means higher prices and higher published inflation goes without saying. It’s still unclear as to whether and at what pace the demand for goods will normalise as infection rates decline. There’s also uncertainty, and again, there’s that word uncertainty as to how quickly the supply and distribution problems will be resolved. He then reinforces the potential temporary nature of recent inflation rises. When he concluded, We can’t rule out the possibility that some of the recent price increases are reversed as a more normal balance between supply demand is re-established.
In any case, for inflation to be sustained at current rates, the prices of many goods would have to keep increasing at their current rates, not just settle at higher levels. All of this means that there are significant uncertainties as to the persistence of the recent price pressures. He then makes a very critical conclusion. The point here is that there are many unanswered questions. We’re unlikely to know the answers quickly. There are many moving parts on both the demand side and the supply side of the economy, and it will take time for these various issues to be resolved. This is relevant to the board’s deliberations about monetary policy. Now my obvious reading of this is that the RBA is in no hurry to make any knee-jerk changes to temporary disruptions until things settle down sustainably. He then turns his attention to ongoing Reserve Bank monetary policy. And he said the cessation of our bond purchases, which is called quantitative easing, does not represent a tightening of monetary policy and drilling down into right expectations.
The decision to end the bond purchase programme does not mean that an increase in the cash rate is imminent. And with this background, RBA Governor Lowe finally addressed interest rates where he stated, “As I’ve said on previous occasions, the board will not increase the cash rate until inflation is sustainably within the 2% to 3% range and big emphasis on that word sustainably.” He went on to explain that the actual rate of inflation is relevant, as are the trajectory and the outlook. So, too, was the breadth of price increases and the factors that are driving them. Based on the evidence we have, it’s too early to conclude that inflation is sustainably in the target range. In terms of underlying inflation, we’ve just reached the midpoint of a target range for the first time in over seven years, and this comes on the back of very significant disruptions in supply chains and distribution networks, which would be expected to be resolved over the months ahead. It all comes at a time when aggregate wages growth in Australia remains low. Is that a right that is unlikely to be consistent with inflation? Banks have signed around the midpoint of the target range. As I discussed earlier, there’s a range of significant uncertainties here that will take time to resolve. We’re in the position where we can take some time to obtain greater clarity on these various issues. The board is prepared to be patient and again, I underline that word patient as it monitors the evolution of the various factors affecting inflation in Australia. He then says we have scope to take the time to there’s still a balance between supply and demand in the economy over the course of this year. We’ll be watching how the various supply side problems resolve and the effects on prices will be watching.
Consumption patterns and whether they normalise will also be looking for further evidence that labour costs are growing at a rate consistent with inflation being sustained within the target range. We expect this evidence to emerge over time, but it’s unlikely to do so quickly. So what’s the very clear take-home message from the RBA? RBA Reserve Bank governor speaks with the Reserve Bank is going to be in no hurry to raise interest rates any time soon until they’re confident that the underlying inflation is sustainably in the two to three per cent range, which means consistently over time, not just the one hit wonder that’s just occurred. So why keep interest rates low with the outlook so positive with the RBA governor put forward two very clear reasons. Firstly, while the Reserve Bank has an optimistic outlook for the year ahead, there’s still a great deal of uncertainty around what the year is going to bring. The bank wants to make sure that economic gains are locked in before it takes its fall off the accelerator. The cost of overheating the economy are actually relatively minor compared to what could happen if it hit the brakes by raising rates too early, and a new COVID variant tips the economy back into recession. Secondly, the current big handbrake is that wage growth remains weak. The economy won’t be on a stable upward trajectory until wage growth picks up from its historic lows. And although the RBA expects wage growth to lift, he believes it’ll be quite a while yet before it climbs above the minimum of 3% needed to keep inflation within the target band. Hence, the reason why I believe that the RBA’s cash rate and related home loan interest rates aren’t likely to go anywhere, at least until late this year, and potentially well beyond and in the federal election.
That’s going to be added in in the first half of the year and ongoing potential COVID variant responses, you can be confident that rates are likely to stay where they are. There are also some other underlying reasons why rates aren’t likely to increase fast. As revealed recently by respected economic commentator Alan Koehler, the reality is that the last rate increase occurred way back in November 2010. That’s over 11 years ago, and since then over 1.1 million first home buyers, many whom have borrowed to the MAX, have only seen rates decrease during this decade of cheap, low rate money. Our appetite for debt has increased substantially, with the debt as a ratio of income climbing from 0.6% In 1991 to 1.8% In 2021. That’s an increase of three times the debt to our income. And even more interestingly, when the last rate rise occurred in 2011, the average mortgage was around about $360 000 with repayments at approximately 2700 hundred bucks a month based on variable rate home loans at the time with a rate of about 7.5%. Now, the average mortgage day is almost doubled to just over $600 000, and if home loan rates increased over the next few years, back to that 7.5%, which is actually the average home loan rate if you look at history over the last 30 years, which would mean that repayments would increase to over $4400 a month, that’s quite a significant increase in repayments of over $1700 a month. Now the service is increased without affecting your lifestyle, your taxable income would have to increase by about $35 000 gross per year. But the average annual wage increases over this last 10 year period has only gone up about $13 300 since 2010.
So this increased debt burden to you and I, together with the massive debt that the government has taken on during COVID to stimulate the economy, means that it would be very difficult and actually very risky for the RBA to normalise interest rates at historic average levels. They’re creating major economic challenges to household spending and general economic confluence. This would be a recession in the making and hence my belief that low rates are going to be with us for quite some time yet. So in my opinion, we can all calm the jets on interest rates going through the roof in the short to medium term. But one thing’s for certain. The next move in interest rates, when eventually does occur will be up and the banks may decide to lift their variable home loan rates marginally independent of the RBA, just as they’ve done with fixed rates in racing terms. Although recent downward movements in variable rates would tend to discount this. So what, if anything, do you need to do about the future prospect of rising rates, regardless of when it actually happens? Well, the answer is always. It depends. It depends on your situation and your risk appetite now. I’m always a believer in planning for the worst and then expecting the best. So if you are a current homeowner who’s looking to minimise your home loan repayments, I suggest sticking with discounted variable rates. But make sure you talk to a savvy mortgage broker to ensure that you’ve got the lowest cost loan. As as an example, our Know How Finance team is saving borrowers anywhere between $400 to $1200 a month just simply by refinancing. Now, if you’re a home borrower who can’t deal with uncertainty, then I’d suggest splitting your line by fixing part of your loan.
Even though fixed rates are considerably higher than variable at the moment, but leave an amount variable so that your offset account still operates and you’re still able to make extra payments because most offset accounts cease to function when you fixed the rate. If you’re a renter who’s looking to become a potential home buyer, start paying notional rent at the level of a higher mortgage, with the extra going into a savings account to ensure that you’ll be comfortable affording the increased repayments when you buy a home and at the same time, you’ll actually be increasing your savings deposit. And finally, if you’re a property investor, make sure you reach out to a savvy mortgage broker to ensure that your loan structure and loan costs are minimised while still preserving maximum tax deductibility and minimising the risk. In summary, the next move in interest rates is likely to be up, but it’s not likely to be by much and not for some time yet. So stop listening to the mass hysteria media and always get your information straight from the horse’s mouth, not a whispering wall.
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