The governor of the Reserve Bank of Australia has told borrowers to prepare for higher interest rates as the economy approaches the ‘other side’ of the pandemic.
The RBA’s November board meeting signalled a shift in the outlook for interest rates, with the central bank’s governor conceding, for the first time, that an early interest rate rise could be on the cards.
Over much of this year, RBA Governor Philip Lowe had said the economic conditions needed to justify a rate rise were not expected be met before 2024, however, that timeline has now become less certain.
“At the outset of the pandemic, economic policy, including monetary policy, set out to build a bridge to the other side. That other side is now clearly in sight,” Mr Lowe said in a webinar following the November interest rate decision.
Having held interest rates at a record low of 0.1% for the past 12 months, Mr Lowe said both lenders and borrowers “need to be aware” that interest rates will rise again.
“They’re not going to rise again quickly and I think they’re not going to rise next year. The most likely case is still 2024 but it’s possible that they go up in 2023,” Mr Lowe said.
“So when people are making their borrowing decisions, they need to factor that into their calculations.”
Could interest rates go up even sooner?
Financial markets have been pricing in an interest rate hike by mid next year after stronger-than-expected inflation data pushed annual underlying inflation to 2.1% in the September quarter, and back within the RBA’s 2-3% target range for the first time in six years.
However, in a speech last week Mr Lowe remained firm that interest rates would not rise before 2023.
“I would like to repeat a point I made a couple of weeks ago – that is, the latest data and forecasts do not warrant an increase in the cash rate in 2022,” Mr Lowe said.
“The economy and inflation would have to turn out very differently from our central scenario for the Board to consider an increase in interest rates next year.”
There’s debate over whether the current spike in inflation is being driven by temporary factors, such as supply chain disruptions and global timber shortages.
Mr Lowe said the labour market would be a key factor in ensuring inflation remains on target and said it’s likely wages growth will need to be growing at “3 point something per cent” to boost inflation to the middle of the target band.
Data released on Wednesday by the Australian Bureau of Statistics showed the annual rate of wages growth was 2.2% by the September quarter – well below the 3 point something Mr Lowe said is needed.
“It is likely to take time to meet the condition we have set for an increase in the cash rate and the Board is prepared to be patient.”
However, several leading economists say the RBA is still too cautious about the outlook for interest rates.
Soaring vaccination rates have allowed locked-down states to reopen earlier than initially thought, prompting economists at the Commonwealth Bank to bring forward their expectations for the first interest rate hike to November 2022.
AMP economists are also tipping the first rate rise to occur in November 2022, saying a boost in consumer spending post-lockdowns could lead to further persistent price rises in goods and services.
“Consumer incomes are in a good shape and savings are higher compared to pre-COVID levels in developed countries, thanks to government fiscal transfers to households during the pandemic,” AMP economist Diana Mousina said.
“So, while the RBA may look through some of the rise in underlying inflation for now, price pressures are building and rate hikes are getting closer in Australia.”
ANZ and Westpac economists both expect the RBA to hike interest rates in the first half of 2023, while NAB is predicting mid-2023.
How much will interest rates rise?
The next million-dollar question is once interest rates do begin to rise; how high will they go?
Mr Lowe said borrowers should be prepared for an eventual cash rate of “at least 2.5%” and perhaps 3.5%. Currently, the official cash rate is at just 0.1%.
“We are trying to get interests up over time. We are in no hurry, we’re patient, but if we are successful interest rates will go up,” Mr Lowe said.
“People borrowing today need to remember that.”
Mr Lowe welcomed the recent move by the banking regulator APRA to increase serviceability buffers on new loans, to ensure borrowers aren’t overstretching themselves.
“We don’t want to see credit growth being really elevated over a long period of time.”
During the pandemic, households have taken on larger home loans than ever before as record low interest rates spurred a lending frenzy.
PropTrack economist Paul Ryan said any moves in the cash rate would be slow and gradual as the economy moves out of a period of exceptionally low interest rates.
“Any interest rate increases are likely to be modest at first, as low interest rates have led many households to take on large amounts of debt,” Mr Ryan said.
Westpac economist Bill Evans said it wouldn’t take too much of a rise in the RBA cash rate for households to feel the squeeze.
“Our expected peak [in the cash rate] is only 1.25% and we’re deriving that from the outlook for household indebtedness,” Mr Evans said.
“Given the huge lift in household debt in response to the very low interest rates and the surging housing market it’s not going to take too much of a rise in the RBA cash rate to really start to impact upon households.”
Westpac is forecasting the first RBA hike in February 2023, to be followed by additional hikes in the June and December quarters of 2023 and another two hikes in 2024 to take the official cash rate to a peak of 1.25%.
Australia’s largest lender, CBA, also expects a peak of 1.25%, however it’s tipping that level will be reached by the end of 2023.
CBA economists have pencilled in two rate hikes in November and December next year, followed by three further moves over 2023, taking the cash rate to 1.25% and the level they assess to be “neutral” based on household debt servicing. A neutral rate is the rate required to support full employment and stable inflation.
“Overall we expect it to be a shallow and gradual tightening cycle given the elevated level of household indebtedness,” CBA head of Australian economics Gareth Aird said.
What it means for mortgage rates
Already, the major lenders have begun preparing for higher funding costs by hiking several fixed-term mortgage rates. However, variable rates have been trending lower as competition in the home loan market keeps pressure on lenders.
According to the RBA’s latest statement on monetary policy, in September, interest rates on new variable rate loans were on average 60 basis points lower than at the end of February 2020.
“Pricing of short-term fixed-rate housing loans remains competitive. However, after a period of strong growth in fixed-rate loans, competition in housing loans may be shifting back towards variable rate loans,” the RBA said.
Mr Ryan said fixed mortgages, particularly longer term fixed rate mortgages, will continue to increase.
“But we are unlikely to see upward pressure on variable rate mortgages in the near term – particularly for owner-occupiers, for whom competition among lenders is strongest,” Mr Ryan said.
“For existing borrowers, they may see higher interest rates, and increased repayments, earlier than they had expected.”
DISCLAIMER: The information contained in this article is correct at the time of publishing and is subject to change. It is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, Smartline recommends that you consider whether it is appropriate for your circumstances. Smartline recommends that you seek independent legal, financial, and taxation advice before acting on any information in this article.