Why Rates Will Rise

In 1990, interest rates went from 12 to 17.5% in six months.

Commercial loans went as high as 22% and unemployment rocketed.

Reason: The economy was going full throttle which sent inflation soaring. Consequently, the RBA hiked interest rates to cool things off and very soon we got the recession ‘we had to have’.

I remember it well. A heap of friends returned to university in 1991 to do honors and master’s degrees because they couldn’t get jobs.

Back then inflation hit a high of 7.2%. It normally oscillates between 2-3%.

And now it looks like we’ve gone retrograde 30 years because this week inflation hit a 30 year high of 6.2% in the US.

The problem is, inflation has shot up much more than the central banks expected.

i.e. the US Federal Reserve and the Reserve Bank of Australia have underestimated the effects of ultra-low interesrt rates.

In turn, this is now putting upward pressure on interest rates, much sooner than expected.

So what’s driving inflation?

It’s simple. You know the trillions of dollar’s worth of stimuli that’s been pumped into world economies over the past 18 months, well the chickens are now coming home to roost.

The only problem is, they’re the size of emus!

In summary, there are two main forces driving inflation which is putting upward pressure on rates.

On the one hand, we have ‘supply side’ or ‘cost push’ inflation (a shortage of energy and labor) which is forcing up input costs for businesses. Where possible, these costs are being passed onto consumers.

And then on the other hand, we have ‘demand side’ or ‘demand pull’ inflation (wage pressures and excess cash) which is giving consumers more spending power and forcing up the prices of goods and services even further, including assets.

So what will this do to interest rates?

Well, in the past 12 months, short term rates have gone from 0.27% up to a recent high of 0.88%.

Meaning, we’ve seen the bottom of the interest rate cycle and you won’t get the same ridiculously cheap deals from the banks you were getting just a month ago.

However, long term rates are the biggest concern.

Before the pandemic, interest rates were at 2.5% before they were cut to 0.1%.

And that’s where our problems start…

If interest rates went back to just 2%, it would slam dunk us into a recession because of the massive rise in debt levels over the past 18 months.

The repayments would cripple consumer spending.

The problem is, inflation is about to scream and interest rates are the only way of slowing it down.

Have a great weekend!

Adam

Back paddock – change is inevitable, except from a vending machine. – Robert C. Gallagher