Borrowers need to prepare for interest rate movements

Borrowers need to prepare for interest rate movements
Zoe FieldingDecember 7, 2020

Interest rates have been on hold at record low levels for more than a year now and experts predict there will be no increases for several more months to come.

But when rates turn, they can move quickly and borrowers should be prepared.

The Reserve Bank of Australia cut rates from 7.25% in August 2008 to 3% in April 2009 in a rapid response to the financial crisis. At the start of the recovery, official interest rate rose from 3% up to 4.5% in the eight months to May 2010.

Interest rate movements can still be volatile but the highs and lows have smoothed out over the past 20 years. Rates are now generally lower than they were. In the early 1990s and before the official cash rate was 17%. Fortunately for mortgage holders, economists agree it’s unlikely the RBA will need to lift interest rates as high as that again.

“The key driver of that story is that inflation is now much lower than it was in that earlier period,” says HSBC chief economist Paul Bloxham.

In the 1970s and 1980s, inflation was running at around 7 to 8%. Now it is between 2 and 3% and Bloxham says these lower inflation rates are expected to persist.

“That’s four to five percentage points that have come off interest rates because inflation is much lower than it was,” Bloxham says.

The RBA uses the short-term interest rate to try to control growth in the economy and keep demand increasing in line with supply. When the economy is weak, the RBA lowers the official interest rate to try to boost demand and when it is too strong, it lifts the interest rate to slow things down.

“They only have the interest rate to do that. They use the cash rate and yes, they have been successful,” Bloxham says.

BetaShares chief economist David Bassanese agrees.

“[The RBA] can achieve an increase in the real interest rate – that is the nominal interest rate less inflation - with a lower nominal rate,” he says.

Expectations of inflation have lowered since the 1990s which in itself slows the inflation rate, Bassanese says.

Labour and product markets are more open to trade and more competitive than they used to be. Competition and deregulation helps keep prices down and reduces demand for wage rises.

“You can get a situation where pockets of strength like in the mining sector don’t flow through to other sectors as easily as they did in the past because it’s much more deregulated,” Bassanese says.

The outlook for energy prices is more benign now than it was in the past, which will also help to keep inflation under control, Bassanese says.

In the 1970s and 1980s, world economies faced oil price shocks, which hit inflation rates. The price of oil for energy skyrocketed in the 1970s due to shortages sparked by tensions in the Middle East. That led to a slowdown in world economic growth in the 1980s, which in turn resulted in a glut of oil that caused oil prices to plunge.

“The other issue is that households now have a lot more debt,” Bassanese says. “Household debt to income has gone from 50% to 150% over the past couple of decades so now interest rate changes have a much bigger impact.”

Households are much more sensitive to interest rate changes, so the RBA doesn’t have to move them around as much as in the past to influence consumer behaviour.

Global factors are also having an effect on Australia’s interest rates, Bloxham says.

Interest rates in the rest of the world are much lower than they have been in the past, particularly since the global financial crisis. They are expected to stay lower, which will also help the RBA to keep Australia’s cash rate down.

Zoe Fielding

I am a freelance journalist and editor with more than 15 years experience specialising in personal finance, property, financial services and financial technology. A skilled writer and researcher, I have extensive experience producing high quality content for corporate and media clients. I am used to working to tight deadlines and tailoring the pieces I produce to suit a variety of audiences and formats.

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