Are you prepared for an interest rate rise or two?

How well-positioned are you for a significant interest rate rise?

Each month the board members of the Reserve Bank meets to discuss the state of the economy and set official interest rates, and two weeks after each meeting they release the minutes from the meeting to explain the reasons behind their monetary policy decision.

A comment in their latest minutes created a stir as the RBA announced it considered a neutral cash rate to be 3.5%.

The current official cash rate of 1.5% is expansionary, or stimulatory, and eventually once these low rates work and the economy improves, employment picks up and inflation increases, the RBA will need to raise interest rates by up to 2% (to 3.5%) for them to be neutral.

In other words, not so low that they stimulate the economy but not so high that they stifle economic activity.

Will interest rates really rise by 2%?

Former Reserve Bank of Australia board member John Edwards recently received significant publicity when he predicted that interest rates could be hiked eight times in the next two years —in other words, by 2%. 

His comments are in line with the RBA’s thoughts that a neutral cash rate could be 2% higher that the current rate.

This has many economists worried as the effect of rising interest rates on the average Australian household is going to be far more dramatic than on previous occasions due to the sheer scale of Australia’s household debt.

Of course the RBA will only increase interest rates to slow down a booming economy, so if rates do rise significantly, the assumption would be that we are in the comfortable position that everybody who wants to have a job would be able to get one, house prices would have increased even further and inflation would be creeping up.

Here is why I think that scenario is a long time off

Now I’m no expert on rates — every time I lock into a fixed interest rate facility rates seem to drop even further. However, I see three reasons why it’s unlikely for rates to rise soon.

APRA and the banks are doing the RBA’s job for them

In an effort to slow the runaway Melbourne and Sydney property markets, the Australian Prudential Regulation Authority’s (APRA) macro prudential controls have tightened lending criteria, especially for property investors, creating a credit squeeze, which really has the same effect as raising interest rates.

At the same time the banks have raised interest rates for investors, meaning the RBA can keep its official rate low to help stimulate businesses and our economy.

The RBA wants a weaker Australian dollar

Currently the Australian dollar is buying around US80 cents, but the RBA would like the dollar to slide closer to US70 cents to help our exports.

Of course, raising interest rates would see cash flow into Australia, lifting the dollar higher.

The world’s economy is still weak

Australia does not operate in isolation, and overall world economic growth is still shaky and China’s medium-term economic outlook is uncertain.

This does not bode well for our exports, which means Australia’s general economic growth will likely remain subdued and won’t be able to handle an interest-rate increase anytime soon.

The bottom line

We are in a low inflationary and low economic growth environment and in its minutes, the RBA board suggested it will be some time before it raises interest rates as inflation remains below their desired 2-3% target band.

However, it is likely the next movement will be up and, in the past, when the RBA raised rates they increased them by 0.25% increments a few times in a row.

Are you ready?

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