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September 2022 Newsletter
Why is the Reserve Bank of Australia
raising interest rates so quickly?
Over the last 4 months we have seen interest rates in Australia rise in five instalments from 0.10% to 2.35% with more increases expected to come. That has an effect on everyone and is widely covered in the press with people making all sorts of predictions even though nobody can be sure which way they will go.
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Have you ever wondered what the economics and theory are behind increasing interest rates? The reason interest rates have been rising is because we are suddenly experiencing large amounts of inflation worldwide and Australia’s inflation to June was 6.1%, which is deeply worrying for the Reserve Bank.
It is deeply worrying because once everyone expects inflation to be high, people adjust and raise prices, and wages go up regularly, and high inflation damages a lot of mostly poorer and less wealthy people as their wages go up by less than inflation.
Persistent inflation also erodes trust in the currency and in politics in general as high inflation is usually associated with bad government.
Economic theory says that when you have sudden jumps in inflation it is really important to knock inflationary expectations on the head and the quickest way is to raise interest rates sharply. Higher interest rates ‘cool’ the economy, i.e. people upgrade their homes less often or don’t qualify for a loan in the first place, businesses abandon projects because the financing costs are too high, consumers reduce their spending as mortgages and credit cards take more of their income and so on.
When demand reduces then those who sell goods and services are often forced to reduce their prices in order to attract their now more picky clients.
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Reduced prices are the definition of reduced inflation. Hence the interest rate rises in an attempt to reduce inflation.
Another way to cool the economy is also happening at the moment as energy prices have gone up between 25% (Australian retail electricity prices) and 900% (UK gas prices). Those extra costs have a very similar effect to higher interest rates as many projects become too expensive and people reduce consumption by driving less and trying to use less energy in general. Woollen jumpers tend to do well during such periods.
Australia is a big beneficiary from higher energy prices so we are less affected than many other parts of the world but we still notice the effect.
In addition, the current inflation is largely imported through higher energy prices and higher costs of imported goods as everyone simultaneously decided to renovate and upgrade their home, leading to much higher building material and consumer good costs exacerbated by Covid related supply chain shortage, but that is now slowly reducing.
It is pretty impossible to predict interest rates – the Reserve Bank got it badly wrong in 2007 when it quickly raised interest rates and then dropped them even more quickly when the global financial crisis hit. Hence my opinion is just an opinion but I can’t see interest rates rising too much because demand is already being hit by higher energy prices.
However, the Australian government just borrowed $100 billion and spent it on a lot of unproductive items like jobkeeper and paying people to stay at home. That money went somewhere, while the amounts of goods and services available didn’t increase substantially. If demand is big and there is lots of easy money then prices tend to go up and sometimes very quickly. If the government keeps running big deficits then we may have higher interest rates for a long time. If inflation drops quickly and stays low, then interest rates will also be able to come down quickly. Either scenario is possible at the moment.
One of the stranger effects has been on fixed mortgage rates. Recently one could get a 2.35% variable home loan or a 1.99% fixed home loan. Currently one can get a 4% variable rate home loan or a 6% fixed rate home loan and in the past fixing your rate has always been worse than staying variable when fixed rates were higher than variable rates. Now a lot of people are fixing rates at a much higher percentage than variable rates because they can’t afford interest rates to go any higher while just being able to afford 6%. Very few people expected for mortgage rates to increase so quickly but not fixing when rates were very low was a big missed opportunity.
We don’t know where interest rates are going but we hear from property developers that they are so far quite optimistic that rates won’t increase much more – some more but not much more – and then may even go down and they are planning accordingly but those same people – and everybody else – did not expect inflation to take off so suddenly and strongly either.
In other words, nobody knows and it is a good time to be prudent and to have cash available if you have loans to be able to deal with eventualities and for those who have large amounts in cash or term deposits the interest rate rises are good news as they finally get some returns on their money again as for every borrower there has to be a lender.
In a nutshell we are living in uncharted waters and as always there are plenty of people ready to create fear or make big predictions. Steady the ship and keep a buffer available if you can.
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We look forward to hearing from you.
Christoph, Nicola, Marian, Clare, Deryk, Alvin and Jade
Christoph Schnelle
Financial Adviser and Life Insurance Specialist
AFP LRS GradDipFinPlan
Life Risk Specialist | SMSF Specialist Advisor
MBiostats | GStat Graduate Statistician
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