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OPINION: Interest rates are too low and will rise

Hands holding wallet with australian dollars to signify changing interest rates.
Rising interest rates will spell the end of cheap and easy money. (Source: Getty)

Interest rates in the United States are about to rise as its central bank, the Federal Reserve, starts work to bring inflation back under control.

An interest rate hike in March is seen as a near certainty, which is broadly expected to be the first of four hikes in 2022.

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Annual inflation in the US is 7 per cent, the highest in almost 40 years. At the same time, wages growth is surging as the unemployment rate dips to just a few tenths above a 50-year low of 3.9 per cent.

It is a similar theme elsewhere in the industrialised world. Inflation has jumped either a lot or a moderate amount just about everywhere you look.

This means one simple thing: interest rates are too low and are set to increase.

Near-term interest-rate hikes are expected not only in the US but in Canada, the UK and here in Australia.

The Reserve Bank of New Zealand, which already hiked rates in October and November to 0.75 per cent, is preparing for yet higher rates too.

The end of cheap and easy money is about to unfold.

Borrowers and mortgage holders beware

For Australia, higher interest rates will present a situation not witnessed since November 2010, which is the last time the RBA delivered a hike.

This means for anyone who has taken out a mortgage at any stage over the past 11 years, there have only been lower or steady interest rates.

Man looks shocked while reading a letter outside a home front door.
Many mortgage holders are likely to soon receive an unwelcome letter from their bank. (Source: Getty)

These borrowers have never had an email or a letter from their bank asking them to increase their fortnightly or monthly repayments.

Instead, even modest pay rises and the cash flow benefits of lower interest rates have fed a boom in household consumption spending, which was as intended. But it is now feeding into inflation pressures.

The interest rate equation is about to change.

When the RBA hikes rates, some recent borrowers will have to increase their repayments.

For many others, who kept the dollar amount of their repayments steady as interest rates were cut over the past years, there is a cash buffer in terms of the amount the principal of the loan has been reduced.

There is also a repayment buffer that will ensure, for the bulk of mortgage holders, there will be no need for higher repayments until the interest rate at which the loan was taken is eventually matched with RBA hikes.

This means the RBA, as it tightens policy to ensure its inflation target is met, will have to hike more than it otherwise would to get the effect of dampening demand and with that, inflation pressures.

Expect series of hikes over next 2 years

The widespread over-payment of mortgages is good news for most householders, but it suggests the first 100 basis points or so of interest rate increases will have a muted effect on their finances, such is the principal and repayment buffer the vast bulk of mortgage holders have.

To cool spending growth and contain inflation, interest rates need to rise to a level that dampens spending.

At the moment, the futures market in Australia is pricing in 150 basis points of interest rate hikes over the next two years.

This looks to be a significant underestimate of the magnitude of interest rate hikes that will be needed to ensure inflation does not exceed the top end of the RBA’s 2 to 3 per cent target band for an extended period.

While circumstances can and will change over that time frame, hikes of about 300 basis points might be needed to take some of the heat out of the economy and deliver an inflation rate entrenched around the middle of the target range in concert with the labour market being fully employed.

It is also important to note that rate hikes may have had some of their potency eroded by the surge in household savings.

Rate hikes will boost the incomes of savers as deposit interest rates also increase, giving a substantial proportion of the population additional spendable income.

It will be a fascinating few years ahead for monetary policy but, as global inflation rates remain elevated and the world’s central banks hike interest rates, Australia will follow.

Get set for a series of interest rate increases over the next couple of years.

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