Up and up: What does an interest rate rise mean for Australia?

UNSW Business School Professor Peter Swan explains what a rate hike would mean for borrowers and the Australian economy.

With inflation surging in Australia, and cost of living front of mind for consumers (also known at this time of the election cycle, as voters), analysts are tipping that the Reserve Bank of Australia (RBA) will be raising interest rates as of May 3. 

The Consumer Price Index (CPI) came in this week at 5.1 per cent for the annual reading, and rose 2.1 per cent in the first quarter of 2022, according to ABS. The price of food, materials and fuel has surged, with the cost of new dwelling purchases by owner-occupiers also rising. 

But why is rising inflation linked to a rise in interest rates?

• Interest rates are the main tool used by central banks to manage the rates of inflation.  

• In layman's terms, raising interest rates makes borrowing money more expensive, but it can also lead to more returns on savings and super (which earn interest on growth).  

• When borrowing becomes expensive, this can also mean less demand for goods and services.

So, while the RBA’s monetary policy is to keep the official cash rate low since late 2020, the central bank is looking at raising these low-interest rates to combat the rising inflation – something which could very well happen during the current election campaign. 

ANZ was the first of the so-called ‘big four’ banks to change its predictions, and forecast that May 3 will be when there will be an interest hike in Australia, terming the current official cash rate at 0.1 per cent “inappropriate” considering current “inflation pressures”.

UNSW Business School’s Professor Peter Swan explains why analysts are tipping official interest rate rises at this time, what exactly it could mean for homeowner borrowers and what impact interest rate increases may have on the election.

See also: RBA governor Philip Lowe's dangerous game on interest rates

See also: What’s wrong with Australian mortgages? They’re fixed for shareholders, not home owners

Why are interest rates predicted to go up? 

Professor Swan: The inflation announcement on April 27 indicated that inflation over the last 12 months has risen to 5.1 per cent p.a. from a more modest 3.5 per cent.

While this is still lower than in both the US and the UK, the rapidly rising rate of inflation is in part a response to the Reserve Bank of Australia (RBA) policy of an effectively zero interest rate that is stimulating demand. To cut back demand, the RBA will raise the cash rate from effectively zero in a series of steps.

The current rate of inflation at 5.1 per cent is the highest for over 20 years but I believe it will get far worse.

What factors have influenced this push for interest rates to go up? 

Professor Swan: While one of the causes is the over 9 per cent rise in the cost of fuel, the fundamental causes are the excess stimulus payments of about $1 trillion, all from borrowing, and the RBA’s quantitative easing (QE). The latter means printing money to buy Commonwealth securities. For example, bonds to force the price up and hence the yield down to about zero.

When interest rates start going up in a series of steps, the value of these bonds will fall causing sizeable “paper” losses. But the RBA is unlikely to realize these substantial losses by selling bonds.

While the Government blames the war in Ukraine for the global shortage of energy (particularly fossil fuel energy), the steps leading to this shortage commenced well before the war. This was due to the demise of Donald Trump’s energy policies under Biden as the US has gone from an energy-rich to an energy-poor nation. In Australia, State bans on gas exploration and fracking and the Commonwealth’s energy policy have exacerbated this in Australia.

When will interest rates go up in Australia? Could we see it before the election?   

Professor Swan: Yes. While in the past the RBA has indicated a reluctance to raise rates, due to the urgency of the situation it may need to commence raising rates by announcing a very small rise. Yes, this could happen prior to the election but for largely political reasons the RBA may delay until after the election.

See also: State of the states: six politics experts take us on a trip around Australia

Why has the RBA delayed putting interest rates up?

Professor Swan: The RBA should never have forced rates down to an historically low level. Due to past statements (that these low rates would remain in place) it is now reluctant to raise rates.

If interest rates go up before voters go to the polls, what might this mean for the federal election campaign? 

Professor Swan: Rises prior to the election will not exacerbate pain points. But it will remind voters that rates will continue to rise for some time.

What will an interest rate rise mean for homeowners with mortgages? 

Professor Swan: Many home buyers paying record prices for properties may have limited capacity to withstand high-interest rates with their repayments. Recall that in the “recession we had to have” in the early nineties in Australia (as then-Treasurer Paul Keating termed it), with official rates peaking at 17.5% (and non-official rates exceeding 25%). Hopefully, these exceeding high rates will not return.

See also: 2022 Budget expands deposit scheme for first home buyers: a second-best option, with risks down the road

If there is a burst housing bubble in the future, could house prices come down? 

Professor Swan: Yes.

What about non-homeowners: would rising interest rates see cost of living go down? 

Professor Swan: Higher interest rates will lower inflation and thus benefit both savers and non-homeowners generally.

Professor Peter Swan is available to comment further and can be reached at peter.swan@unsw.edu.au.