Interest rates - why they are going up and what it means to borrowers and the market
On Tuesday 3 May, after over a decade of maintaining or decreasing interest rates, the Reserve Bank of Australia (RBA) announced a rise in the official cash rate from the historic low of 0.1% to 0.35%. According to most experts, this is just the first in what is predicted to be a series of incremental rises designed to bring a worrying inflation rate firmly under control, support economic growth, and ensure Australia remains competitive on the world market.
I’d like to break this down a bit more for you and discuss how rising interest rates could affect the property market in the short to mid-term.
What is the cash rate, and who controls it?
Banks lend one another money on an overnight basis to ensure their daily cash needs are met. The cash rate is the official interest rate charged for these interbank loans. However, it’s also the benchmark for most other interest-related products, such as mortgages and savings accounts.
The RBA is our (politically neutral) central bank and the main decision-making body when it comes to monetary policy. It’s the institution responsible for setting the cash rate and operates, according to its charter, to ensure:
a) the stability of the currency of Australia; b) the maintenance of full employment in Australia; and c) the economic prosperity and welfare of the people of Australia.
Why does the RBA decide to raise the cash rate?
There are several factors that can prompt the RBA to change interest rates. The most significant reason for the current 25-point rise to 0.35% is inflation, which we have all felt the impact of in recent months, with consumer prices starting to climb somewhat alarmingly.
A quick look at the Australian Bureau of Statistics consumer price index (CPI) shows that “over the twelve months to the March 2022 quarter, the CPI rose 5.1%,” which is the biggest annual change in the CPI since 2001 and the introduction of the GST. It is also significantly larger than had been forecast by many economists, the RBA, and the Treasury itself.
In the early 1990s, the RBA introduced an inflation target of between 2% and 3%, on average, over time. This was a move designed to help the bank achieve its three core goals and stabilise our economy
Clearly, that target has been exceeded, and one of the mechanisms that the RBA has to fight against excessive inflation is to raise interest rates.
But isn't that going to create more problems with the cost of living?
Although it does seem counterintuitive, raising the cost of living (by pushing up interest rates) can actually help the economy by slowing demand.
Strong demand is great in the right measure. Our economy produces a given quantity of goods and services to meet customer demand. But if demand outstrips production capacity, the market becomes more competitive, with consumers willing to pay higher prices to get the things that they want.
The more demand outstrips supply, the higher the prices soar. And the higher the prices soar, the higher wages workers demand to be able to pay for the things they so want. Higher wages mean higher costs for producers, which they then pass on to the consumers in what becomes a spiralling upwards cycle.
So, by raising interest rates to soften demand to some extent, the RBA is effectively putting the brakes on inflation to help stabilise the economy.
Is this happening anywhere else?
Yes! A quick look at what is happening in around the world shows that there is global inflation, with many countries also experiencing strong inflation and using interest-rate hikes to counter it.
So far, Australia is faring comparatively well. For example, New Zealand’s current cash rate is 1.5%, with inflation at 6.9%, while in the United States inflation is already at 8.5%, though their interest rate is still relatively low at 0.25%.
One extreme case is Turkey, with inflation currently at 61.14% and a cash rate of 14%.
So, there is a clear global trend towards increasing interest rates to curb inflation. But what does this mean in terms of the property market here in Australia? There are two main points to consider; mortgage repayments on current debt and tighter lending restrictions, making it harder to get a new home loan.
Mortgages
In Australia, interest rates have been going down since 2010, which means that the millions of people who have taken out a home loan since then have never had to face the repercussions of rising interest rates.
While having a fixed-rate loan protects borrowers for a time, the fixed-rate term eventually ends, and their loan becomes subject to the ups and downs of the financial market.
This current 25-point hike is expected to be the first of several over the coming year, with economists from the Commonwealth Bank and Westpac predicting that the cash rate will hit 1.25% by the end of the year.
If this happens, borrowers with a mortgage of $800,000—the average for an established property in NSW—will have to find an extra $500 or so a month to make their repayments.
And with interest rates generally forecast to follow the upward trend throughout 2023 and 2024, these figures are set to rise further.
Do higher interest rates make it harder to borrow?
The bottom line here is that higher interest rates make it more expensive to borrow money.
This means that banks will be more cautious about lending, and borrowers might have to jump through a few more hoops to show that they will be able to repay a home loan even if rates continue to rise.
On the other hand, higher interest rates can favour people who are saving for a deposit, which might, in turn, boost their ability to secure a loan. There are good and bad sides to everything!
One other player to consider is the Australian Prudential Regulation Authority (APRA), the regulatory body that also works to ensure economic stability by closely supervising financial institutions.
What does APRA do?
Of the many things that the regulator does, the most relevant to us here is that they impose a minimum interest-rate buffer on authorised lenders, such as banks, in order to protect the economy from the threat of ballooning debt. Back in October 2021, APRA increased that buffer to 3 percentage points above the loan product rate.
This means that before approving a loan, a lender is required to test whether a borrower can potentially repay the advertised interest rate plus 3%. In effect, it means that there is already a built-in mechanism to ensure that people who take out a home loan will be able to manage higher repayments in the case of interest rates going up.
This is comforting news for many, who may feel the pinch as rates rise but will also be secure in the knowledge that they are essentially able to meet the increasing cost of their mortgage.
How does this all affect the wider market?
In terms of our property market, the general consensus is that while there may be some uncertainty as people recalibrate after the cash rate rise and the upcoming federal election, demand for properties will continue to outstrip supply for some time. This is especially true in the rental market, where values are climbing, and vacancies are at record lows.
Summing it all up
In these times of global inflation, rising interest rates are a vital safety mechanism to ensure economic stability. It’s true that for many people, it will be a little tougher to meet the demands of their mortgage, although the APRA buffer should settle most debt-induced worries for the time being.
So, perhaps we should try to see the coming hikes along the interest-rate road as speed humps, designed to protect us from the worrying prospect of spiralling inflation, which, on the whole, would be far more damaging to us, as individuals and as a nation.
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