How high will interest rates go?
However, it took the bank about six years – from May 2002 to March 2008 – to roll out its next hiking cycle.
This is partly because in the late 1990s and early 2000s Australian mortgage lending boomed, partly as a result of the liberalization of the banking system, which encouraged competition from banks foreign and small lenders, which drove down lending rates.
Debt got cheaper, so Australians borrowed more. This meant that the same percentage increase in interest rates – applied to a much larger mortgage loan – consumed a much larger share of excess household cash flow.
And the same thing just happened again during the COVID-19 pandemic, with ultra-low rates encouraging more borrowers to take out bigger mortgages. This is a fact of which the RBA is well aware.
Yet central bank governor Phil Lowe warned everyone this week that it was not unreasonable to expect the official exchange rate to return to something like 2.5% at a given time – although he staunchly refused to give a deadline, despite repeated questions from reporters. .
“Over time, it is not unreasonable to expect interest rates to reach 2.5%. How quickly we get there, and if we get there, will be determined by how events unfold,” Lowe said.
Why the escape? Two reasons.
The RBA really doesn’t know how events will unfold. If the past few years have taught us anything, it’s to expect the unexpected. It may be appropriate for the central bank to withdraw all support from the economy and move the interest rate to a level where it is “neutral” – that is, it exerts no effect of stimulation or contraction on the economy (at the moment it clearly still very stimulating).
But it could also happen that some support is still needed. Maybe workers are less successful than expected in getting pay raises. Perhaps there is yet unimaginable economic hell ready to unleash, which means it is still appropriate for monetary policy settings to be stimulative.
The second reason Lowe is a bit vague about where rates are headed is that the bank really doesn’t know for sure what the “neutral” cash rate would be. Estimates vary wildly and depend on a host of external factors, including what the government does with fiscal policy. If the government is spending on the rise, the neutral cash rate may be a bit higher, to ensure that the economy stays in balance. If the government cuts spending sharply, the neutral cash rate may be a little lower, to offset this contractionary impulse.
Nobody – not even the best economists in the country, let alone the media commentators – knows for sure what a neutral exchange rate looks like.
As my colleague Shane Wright made very clear in our Please Explain podcast this week, the neutral exchange rate is a bit like the famous American judge who said of pornography “I’ll know when I see it”.
So, in summary, the Reserve Bank does not know what a neutral cash rate is, or that such a rate is still the appropriate setting. Only time will tell.
So what should mortgage holders think?
Well, it’s definitely time to take a hard look at your household budget and see if you can afford a 2.5% increase in prevailing mortgage interest rates – and, if you can’t , where you can shrink to make sure you can.
You can use the government’s “Moneysmart Mortgage Calculator” (google it) to play around with different scenarios for your loan.
If I cancel my fixed interest rate of 1.84% in the middle of next year in a world where the cheapest variable interest rate in effect will probably be around 4.39% (1.99 % plus 2.4 percentage points), this will mean that my monthly rate of repayments goes from about $2,550 per month to about $3,500.
Luckily, I know I have a monthly budget surplus that can absorb that. Although I suspect I will have to cut back on my vacations or find ways to increase my income to stay comfortable.
Remember that you should have been stress tested by your lender when evaluating your loan, to ensure that you can afford interest rate increases of 2.5 percentage points or more. However, given the modest estimate of living expenses that loan appraisers typically apply, things could be about to get tough for many borrowers.
No more Shiraz and Wagyu for you – or me – my friends. But don’t worry too much: mince and water can do just fine.
- The advice given in this article is of a general nature and is not intended to influence readers’ decisions regarding investments or financial products. They should always seek professional advice that takes their personal circumstances into account before making financial decisions.
Jessica Irvine is the author of the new book Money with Jess: Your Ultimate Guide to Household Budgeting. You can follow Jess’s other money adventures on Instagram @moneywithjess and sign up to receive her weekly email newsletter.