Contributor: Troy Hampton, Financial Adviser
Why are interest rates rising?
Interest rates are an instrument with which central banks can control the level of domestic inflation. By raising or reducing interest rates, central banks can influence the amount of free cashflow available for retail consumers and businesses. When inflation is high, Central Banks will lift rates resulting in people spending less resulting in generally less demand for goods and services.
Why is inflation bad?
Inflation isn’t inherently bad, although sustained high inflation or low inflation can impact the wider economy. For example, if inflation is continuously running at 6-8%, which has been the recent case, then wages and business revenue would need to grow at the same rate to ensure that people can afford their lifestyle. Likewise, retirees need to gain an additional 6-8% p.a. return from their investments to keep up with the increased cost of living.
The great inflation of the 1970s
It’s important to learn from the past, and the best example of high inflation and fast increasing interest rates was in the US in the 1970s. Inflation was at 1.59% in 1965 and had risen to above 11% by 1974. The US central bank was too slow to act, prioritising unemployment over inflation, and consequently had to raise the US cash rate above 20% to curb the long-term high inflation. Thus, the US was in recession from 1973-1975 and again periodically between 1980 and 1982.
Why we (probably) won’t get 10% interest rates this time
The current high debt-to-income ratios suggest that even small changes in cash rates have a larger impact on household expenditure than in the past. By many accounts there’s data indicating that inflation has now peaked, meaning interest rate rises are likely to slow or pause in 2023.
Investment markets
Most investment markets don’t like high interest rates. For the share market, a company’s revenue is required to grow faster than previous years to retain their value, because investors now have the ability to get a higher return with defensive assets. For property, there are usually less people willing to take out debt to finance a purchase, thus pushing prices lower. And for bonds, the bond that was issued 2 years ago at 3% now must be issued at a much higher rate to entice investors, in turn making previously issued bonds less desirable.
Summary
Although there’s no crystal ball, we believe that central banks are taking necessary action to ensure that inflation is controlled before long-term systemic issues can arise. There will certainly be some short-term pain for borrowers, however the worst appears to be behind us with potential rate cuts coming in 2024.
If you have any questions about interest rates or inflation, please contact your adviser.
