How will the new Interest Rate regime work ???

Interest rates: Another step to ‘normality’
Reserve Bank Board meeting

• The Reserve Bank has lifted the cash rate from 3.75 per cent to 4.00 per cent. If banks fully pass on the rate hike then repayments on an average $300,000 loan would lift by just over $47 a month.
• The Reserve Bank has given no guidance on future rate decisions other than highlighting the fact that borrowing rates should “be closer to average”. Overall, that suggests rates have another 35-70 basis points to go.

What does it all mean?
• It’s important not to over-analyse the latest interest rate decision. The Reserve Bank has lifted the cash rate for the simple reason is that it is still too low for an economy that is getting back to normal. And if the economy continues to improve, then we can expect the Reserve Bank to lift rates further.
• Certainly the rate decision will be ‘live’ for the next few months. The Reserve Bank doesn’t want people to assume that it has tunnel vision – that is, it is fixated on some specific interest rate goal. But the Reserve Bank Governor has provided good broad guidance, noting that interest rates are around 50-100 basis points away from ‘normal’. CommSec has consistently noted that the cash rate will be between 4.50-5.00 per cent late in 2010 and there has been nothing of late to sway us from that view.
• The one point that should always be kept in mind when rates are rising is that just a third of the population is in the process of paying off home loans. Another third are renting and the remaining third of families own their homes. The home-buying population wouldn’t be shocked by the rate decision – many of the longer-term mortgagees would be well in front in their repayments. Renters would be unfussed by the rates decision with anecdotes that some landlords are offering incentives at present such as the first month free. And home-owners would be cheering the lift in interest rates with a view to higher term deposit rates.
• When the Reserve Bank is contemplating monetary conditions in the economy, it isn’t just thinking about the cash rate and interest rates applied by lenders. It also has to keep in mind the Aussie dollar. The Aussie dollar remains strong, hovering near US90 cents and at 25-year highs against the British pound. The high Aussie may be good news for travellers, but it is keeping the pressure on exporters and tourism-dependent regions.

Interest rate decision and past cycles
• The Reserve Bank Board has lifted the cash rate by 25 basis points to 4.00 per cent – the first rate hike since December last year. In October 2009 cash rates stood at a 49-year low of 3.00 per cent. After quarter percent rate hikes in October, November and December the cash rate stood at 3.75 per cent. Rates were left unchanged in February before today’s decision to lift rates again.
• In the last rate cutting cycle the cash rate fell to lows of 4.25 percent in December 2001. In the two previous rate cutting cycles, the cash rate fell to lows of 4.75 per cent. So rates are still historically low.
• If banks pass on the latest rate hike in full, the average bank variable housing rate would lift to 6.90 per cent. Still, it’s important to note that the mortgage rate has averaged 7.60 per cent over the past 5 years and 7.25 per cent over the past decade. Mortgage rates are still low – up to 70 basis points below longer-term averages.
• The Reserve Bank hasn’t given specific guidance, other than noting that further rate hikes lie ahead: “Interest rates to most borrowers nonetheless remain lower than average. The Board judges that with growth likely to be close to trend and inflation close to target over the coming year, it is appropriate for interest rates to be closer to average. Today’s decision is a further step in that process.”

What are the implications of today’s decision?
• The Reserve Bank is taking its time in lifting rates to more ‘normal’ levels. It knows that it has time on its side. Other major central banks haven’t started lifting rates yet and global jitters still remain. Meanwhile, at home inflationary pressures continue to ease. Add in the continued strength of the Aussie dollar and it’s clear that the Reserve Bank hasn’t got a defined month-by-month plan to lift rates.
• While consumers are confident, they remain cautious about spending. And with interest rates up again, that hesitancy to spend will continue. Larger retailers are better able to withstand this period of consumer conservatism as there are limits to how far and how long smaller retailers can cut margins.
• Competition for domestic funds is expected to remain intense, representing attractive opportunities for savers.
• Ignore any stories about borrowers under pressure as a result of the latest rate hike. The number of borrowers experiencing stress as a result of the latest rate hike would be extremely small. Most borrowers, as well as most lenders, have assumed substantial rate hikes into their planning and budgeting decisions.


Source Craig James, Chief Economist, CommSec