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August 17, 2022 by ash

5 reasons they won’t rise as high as predicted.

As experts frighten the living daylights out of everyone about interest rates, here are five reasons they won’t rise as high as predicted.

Surging costs for everyday grocery items and fresh food, exorbitant prices for fuel and, on top of everything, a series of punishing interest rate hikes from the Reserve Bank adding hundreds of dollars a month to the cost of an average mortgage.

And to top it all off, pretty much every expert you listen to will tell you worse, far worse, is at hand when it comes to interest rates.

But there’s a couple of basic principles most have abandoned in their quest to frighten the living daylights out of everyone. And at the very top of that list is logic.

Australia is uniquely vulnerable to an economic downturn from interest rate hikes for a number of reasons. Unlike the US — where a large number of households have fixed mortgage rates for the life of their loans — our mortgages are struck on variable rates. Even our fixed rate loans are for relatively short terms.

So, interest rate movements directly impact Australian households more than many other countries.

Add in our huge household debt — mostly geared to real estate — and the kind of rate hikes being bandied about by experts would hit the property market hard and potentially plunge the economy into recession.

That would be a disaster. And it would force the RBA to cut interest rates.


Does RBA really want everyone to go broke?

The answer to that is NO — or, at least, we hope that’s the answer.

If you believe all the predictions, official interest rates in Australia are likely to hit 3.5 per cent by mid next year.

Believe it or not, but that’s actually been scaled back a little. A few weeks back, money markets were tipping official rates at more than 4 per cent by mid-next year.

Were that to occur, mortgages would be priced at more than 6 per cent, compared with the rock bottom rates of under 2 per cent on offer early last year.

Just imagine the impact on the 165,000-odd first home buyers who bought real estate last year. Then think about the enormous strain it would place on millions of Australian households that have endured years of anaemic pay rises.

It is a long-established edict of banking that, when it comes to housing, Australians will do almost anything to ensure they keep a roof over their heads, even if it means cutting spending on almost all other essentials.

That’s all well and good. But — while we all bang on about the strength of our economy and our exports like energy and iron ore — it’s worth remembering that around 60 per cent of our economic growth comes from household spending.

If spending falls off a cliff, because of a rapid-fire lift in interest rates, we’ll tip into recession. And then we’ll have a much bigger problem.


Rate hikes hurt more these days

It is not because we aren’t as tough as we used to be, but we certainly are far more vulnerable than we once were.

Back in 1994, the RBA jacked up rates viciously. Between July of that year until December, the official rate jumped from 4.75 per cent to 7.5 per cent. It was done in just three steps, with two of those hikes more like leaps of 1 percentage point each.

So, what’s changed? Have we become wimps?

Not at all. The big change is in the value of real estate and the size of our loans. Back then, the median price for a house in our biggest city, Sydney, was $169,000. These days, the same place will set you back $1.25 million.

That huge valuation jump has been funded with debt, and — because we owe so much more than we once did — the effects of interest rate rises are magnified.

If you compare household debt to income, we are vying for world domination with Switzerland, Netherlands, Denmark and Norway.

As a result, our economy now is hypersensitive to interest rate movements. That means the RBA has less leeway when it comes to interest rates than many other nations. It also means it needs to be much more careful when it comes to rates.


Will rate rises cure the inflation problem?

Eventually, maybe. The question is how much damage they will cause in the process.

Here’s the dilemma: Prices are determined by two factors, supply and demand.

A large portion of the dramatic lift we’ve seen in prices for food, fuel, fertiliser and manufactured goods has been because of supply problems; starting with shipping delays and exacerbated by Russia’s brutal invasion of Ukraine.

And that’s where things get tricky. For interest rates, the only tool central banks have, are designed to impact demand. They won’t fix supply problems.

While it’s true you can wind back demand so that it meets supply, it will end up inflicting far more harm on individuals and the economy in general.

It’s not as though we’ve been out spending like crazy because we’ve had money burning a hole in our pockets. Most already are doing it tough, struggling just to keep their heads above the tide of rapid price rises.

In any case, it’s likely the supply driven inflation problem will cure itself. Think of it this way. The price of carrots may have doubled in a month because of shortages. That’s 100 per cent inflation. However, if they stay at that higher price, then there’s no inflation.

The carrots are still expensive. But the price isn’t rising.


Danger of over-tightening

There’s a delayed reaction when it comes to interest rates. Economists refer to it as “the lag”, which makes it difficult to judge just how much pressure you need to apply to have the desired effect.

It’s like jamming your foot on the brake, having no reaction, then pushing even harder, only to find you’ve locked up the wheels and you’re skidding off the road.

Having started late, every central bank is now in panic mode. America is pumping through triple hikes. We’ve just done two doubles. New Zealand is the same.

There is no doubt interest rates need to rise. We’ve come through a period of, essentially, zero per cent interest rates: Free money.

Throughout the entire history of civil society, 5,000 years of commerce, such an idea was inconceivable — until a decade ago.

It’s caused asset price bubbles in everything from real estate to stocks and even imaginary assets delivered via the internet.

Unwinding those distortions is hugely difficult, potentially painful and with the very real prospect of wrong-footing by policy makers.

That’s why the “normalisation” of interest rates should take years, possibly even decades. It needs to be done slowly, something global central banks recognised last year but, temporarily, appear to have jettisoned in their quest to snuff out inflation.

No-one knows what normal is any more. Central banks, such as the RBA, look for what they think is the “neutral” rate, the Goldilocks level that keeps economic growth at just the right temperature.

It might well be 3.5 or 4 per cent. However, heading there at a blistering pace, as we are now, is a dangerous course of action that has the potential to backfire spectacularly.


Slow hikes … or be forced to cut?

At the start of last year, money markets started going haywire, aggressively pricing in rate hikes as inflation began to reassert itself.

The behaviour was laughed off by almost every global central bank, including our own, which hammered home the point that rates would not rise for years. Eventually, however, they’ve had to capitulate.

However, in their mad rush to catch up with the markets, they’ve slammed the brakes on global growth at a time when China’s economy is in deep distress as the short-term impact of its harsh COVID-zero policies collide with longer-term demographic challenges.

The IMF, World Bank and the OECD have all slashed growth forecasts, while prospects of recession, which seemed slim just a few months back, suddenly have heightened.

America notched-up an unexpected contraction in the March quarter. If, as now feared, the same result occurs in the just-completed June quarter, then — technically — the US may already be in recession.

About a fortnight ago, money markets began a radical reassessment of the future for interest rates. They began scaling them back.

Finally, the penny appears to have dropped. If we keep driving rates higher at this pace, it may have limited impact on inflation and only serve to kill demand, thereby — unnecessarily — creating a recession.

That wake-up call has yet to filter through to many economists, experts and even global central banks, which have become obsessed with just one thing: stamping out inflation.

And that leaves the RBA and its ilk with just two choices: Start dialling back the speed of rate hikes now or tip the economy into recession and be forced to start cutting next year.

The destination will be the same. Rates will be lower next year than many predict. How we get there is the unknown.