Checks and Balances
January 2014
Interest rates in Australia are about to increase, perhaps by quite a lot.
In the months ahead, when interest rates are increased, the Reserve Bank of Australia will be reacting to a pick up in economic growth and inflation that started around the middle of 2013.
For indebted consumers, householders and those in the business sector, the last year or two has delivered a windfall gain in the form of reduced borrowing costs as the RBA cut interest rates to levels not seen since at least the 1950s. The low interest rates have seen interest payments for those with debt fall sharply, freeing up cash flow, which in turn is supporting other parts of the economy.
The current low level of interest rates is a key factor behind some interesting and welcome changes in the economy. Importantly, it has arrested the fall in house prices that was evident in the two years up to early 2012 which was undermining wealth and confidence for many consumers. House prices rose by 10 percent in 2013 and the early signs suggest 2014 is starting on a similarly strong note.
At the same time, the improved cash flow for mortgage holders has seen a lift in spending, at least in the retail sector, to the point where growth in retail trade is running at an annualised pace of 7 percent. Another few months of this sort of growth would risk spilling over to higher inflation.
The business sector is also benefiting from low interest rates, which has seen business investment remain remarkably strong, notwithstanding the inevitable slump in mining. Housing construction is picking up strongly and will add significantly to bottom line GDP growth in both 2014 and 2015.
Lower interest rates have also been helpful, at least to some extent, in driving the Australian dollar lower which in turn has helped the export sector expand and given local firms that compete with imports a competitive boost. From levels around 105 US cents early in 2013, the Australian dollar has settled around 90 US cents, which is probably close to fair value given the economic fundamentals of Australia.
As 2014 kicks off, the RBA needs to be careful not to let these favourable trends get too far advanced, because if unchecked, a surge in house prices, excessive consumer spending and an uncomfortably large devaluation of the Australian dollar would inevitably spark a pick-up in inflation.
Indeed, higher interest rates during 2014 will be a sign of economic strength and the risk of excessive demand growth needs to be dampened by tighter monetary policy.
It is impossible to map out the path of exactly when and by how much interest rates will need to rise in the next year or two. In recent decades, the cyclical peak in the cash rate has been between 4.75 percent and 7.5 percent. The peak has varied depending on the inflation pressures being felt in the economy.
The last peak in the cash rate in 2010-11 was 4.75 percent, well below the prior peak of 7.25 percent in 2008. Prior to that the cash rate peaked at 6.25 percent in 2000 and before that 7.5 percent in 1994 to 1996.
It would be reasonable to expect that the pending monetary tightening cycle will see the cash rate rise to at least 4.75 per cent sometime over the 2015 or 2016, with a peak somewhere around 5.5 per cent or 6 per cent most likely.
This means that borrowers should be preparing for their mortgage and overdraft rates to rise by approximately 3 percentage points within a couple of years.
The RBA has a record of adjusting monetary policy without fear or favour or with much overt regard to financial market pricing. Even though the market is yet to price in higher interest rates, the RBA will move to tighten policy when its assessment of inflation risks changes. The first rate hike could be only a few months away.
A 3 percentage point increase in the interest rate structure over the next couple of years should be sufficient to curtail any unwelcome lift in house prices and yet see the economy grow at a sustainable pace.
For those with high levels of debt, there is likely to be some financial stress, which, incidentally, is what changes in monetary policy are all about. High interest rates are designed to discourage borrowing, spending and investment and encourage savings, which is the reverse of the current low interest rate environment, which is aimed at boosting spending and investment and discouraging savings.
Australia has had enough of the latter fuelled by easy monetary policy. The RBA is poised to move to a more neutral monetary policy stance in the not too distant future.
Stephen Koukoulas is Managing Director of Market Economics
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