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When will interest rates rise?

·4-min read
SYDNEY, AUSTRALIA - MAY 5, 2018: Reserve Bank of Australia building name on black stone wall in the center of Sydney NSW Australia.
(Source: Getty)

Tomorrow we will look at whether now is your last chance to secure ultra-low interest rates. Sign up to our newsletter here to get it straight to your inbox.

The Reserve Bank of Australia has said that it will not raise official interest rates until at least 2024, when it expects the economy to be running at full employment, with solid wages growth and inflation entrenched in the 2 to 3 per cent target range.

This expectation captures the extent of the decade long period of weak growth and high unemployment that was compounded by the COVID-19 recession and still problematic recovery.

But is this guidance from the RBA robust, or will it be forced to change its views and policy actions as circumstances change?

The RBA’s strategy is clear.

By keeping interest rates at 0.1 per cent for an extended period, it wants to see the economy register several years of strong growth. Several years that sees the unemployment rate head towards 4 per cent, a rate that would spark a welcome upside trend in wage and inflation pressures.

Over many years now, the RBA has made errors in its forecasts and policy settings. It is, after all, staffed by mere mortals.

Who can forget the rhetoric a couple of years ago that ‘the next move in interest rates would be up’? This was when the cash rate was 1.5 per cent, inflation was below target and the unemployment rate was entrenched above 5 per cent.

The RBA was also reluctant to cut interest rates because lower rates would ‘unsettle markets’. It was also willing to have a high unemployment rate as it kept monetary policy tight to ‘lean against’ the rise in house prices.

What can go wrong now?

There is growing evidence that inflation pressures, not just in Australia, but around the world are starting to lift.

To be sure, this is from a very low starting point but with all of the major central banks around the world now with stimulatory monetary policy settings and economic growth picking up from the 2020 recession, inflation is starting to move higher.

It is a trend that traders in the bond market have identified.

The 10-year government bond yield, a rough benchmark which includes a judgment about inflation risks, has moved higher. The move is not yet to the point where a material and sustained lift in inflation has been priced in, but the initial rise in yields could well be a starting point for debate about higher interest rates within the next 12 months.

Commodity prices are also booming which is a rough signal of future upside inflation.

Rates hikes equals good news

If the RBA is compelled to hike interest rates a year or 18 months earlier than its current 2024 guidance, it will be a good news story.

It would be doing so only because the economy turned out to be stronger than expected, with wages growth and inflation rising more quickly, and earlier, than it was anticipating in early 2021.

The current monetary policy settings, with the cash rate and 3-year government bond targets at 0.1 per cent, with additional bond buying and a cheap bank lending program, are because the economy is fragile. These settings are incongruous with a strong economy, in full health, with a tight labour market and inflation running within the target zone.

Factor in interest rate hikes, not cuts

To be sure, forecasting the path for changes in official interest rates is open to many variables and no one does it particularly well.

But it would be a mistake, and a big one at that, to think interest rates will be any lower or that they will stay at these levels forever. Even for a few more years.

Over the medium term, interest rates will be higher than today, with the only questions being when the rate hikes will commence and then how much interest rates will rise.

When we look back at interest rates, just prior to the global financial crisis of 2007 to 2010, Australian official interest rates were what looks now to be a staggering 7.25 per cent.

Mortgage interest rates were around 9.5 per cent.

Put that into your mortgage calculator and see how powerful that is on your monthly repayments.

As recently as the end of 2014, the official interest rate was 2.5 per cent with mortgage rates around 4.5 to 5 per cent.

Even those sort of interest rates are enough to make many recent borrowers squirm.

No one is thinking that interest rates are heading back to those levels, at least in the next couple of years, but they will rise at some stage.

Many mortgages are taken out over 25 or 30 years and it is highly likely if not certain that at some stage interest rates will be materially higher during the life of those loans.

To get some insight on the outlook for interest rates, look at inflation, wages growth and the unemployment rate.

When these all reach levels that the RBA is happy with – or at some stage are stronger than considered sustainable, interest rates will rise.

This could be as soon 2022.

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