How high will interest rates go?

However, it took the bank about six years – from May 2002 to March 2008 – to deploy its next hiking cycle.

Part of the reason is that during the late 1990s and early 2000s, the size of Australian mortgages skyrocketed, thanks in part to the liberalization of the banking system, which encouraged competition from foreign banks and smaller lenders that drove down lending rates.

Debt got cheaper, so Aussies borrowed more. That meant the same percentage interest rate increase – applied to a much bigger dollar sum mortgage – ate a much larger chunk of household surplus cash flows.

And the same thing has just happened again during the COVID-19 pandemic, with ultra-low rates encouraging more borrowers to take on bigger mortgages. It’s a fact the RBA is well aware of.

Still, the central bank’s governor Phil Lowe cautioned everyone this week that it was not unreasonable to expect that the official cash rate will return to something like 2.5 per cent at some point – although he steadfastly refused to give a deadline, despite repeated questioning by journalists .

“Over time, it is not unreasonable to expect interest rates would get to 2.5 per cent. How quickly we get there, and if we do get there, will be determined by how events unfold,” Lowe said.

Why the evasiveness? Two reasons.

The RBA genuinely doesn’t know how events will play out. If the past few years have taught us anything, it’s to expect the unexpected. It may be appropriate for the central bank to remove all its support for the economy and move the cash rate to a level where it is ‘neutral’ – that is, neither exerting a stimulatory nor a contractionary impact on the economy (at the moment it clearly still highly stimulatory).

But it could also come to pass that some support is still necessary. Perhaps workers have less success in securing pay rises than expected. Perhaps there is some as yet unimagined economic hell ready to let loose that means it’s still appropriate for monetary policy settings to be stimulatory.

The second reason Lowe is a bit vague on where rates are heading is that the bank genuinely 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 is up to with fiscal policy. If the government is spending up, the neutral cash rate may be a bit higher, to ensure the economy remains in balance. If the government is cutting spending hard, the neutral cash rate may be a bit lower, to offset that contractionary impulse.

No one – not even the top economists in the country, and least of all armchair commentators in the media – know for sure what a neutral cash rate looks like.

As my colleague Shane Wright put it quite vividly on our Please Explain podcast this week, the neutral cash rate is a bit like the famous US judge who said of pornography “I’ll know it when I see it”.

So, in summary, the Reserve Bank doesn’t know what a neutral cash rate is, nor that such a rate is the appropriate setting yet. Only time will tell.

So, what should mortgage holders make of it all?

Well, it’s definitely time to have a good look at your household budget and see if you can afford a 2.5 percentage point cent rise in prevailing mortgage interest rates – and, if not, where you can cut back to make sure you can.

You can use the government’s ‘Moneysmart mortgage calculator’ (google it) to play with different scenarios for your loan.

If I roll off my 1.84 per cent fixed-interest rate mid next year into a world where the prevailing cheapest variable interest rate available is likely to be about 4.39 per cent (1.99 per cent plus 2.4 percentage points), that’ll mean my monthly repayments jump from about $2550 a month to about $3500.

Ouch!

Fortunately, I know I have a monthly budget surplus that can absorb that. Although I suspect I will have to make cutbacks on holidays, or find ways to boost my income to remain comfortable.

Remember, you should have been stress-tested by your lender during your loan assessment, to make sure you can afford interest rate increases of 2.5 percentage points, or more. However, given the modest estimate of living expenses loan assessors usually apply, things could be about to get tight for many borrowers.

Loading

No more Shiraz and Wagyu for you – or me – my friends. But don’t worry too much: thin and water can do just fine.

  • Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

Jessica Irvine is author of the new book Money with Jess: Your Ultimate Guide to Household Budgeting. You can follow more of Jess’ money adventures on Instagram @moneywithjess and sign up to receive her weekly email newsletter.

Leave a Comment