Rising interest rates herald a new investing approach

After 11 years of falling interest rates, the decision to start lifting rates marks a new epoch in savings and investment.

While the main media focus has been on mortgage rates, there are at least five major considerations that flow from the now arrived tightening phase of monetary policy.

One rise will lead to many more

The first one is that this is no isolated rate rise.

Reserve Bank of Australia Governor Dr Philip Lowe made it crystal clear that this will be just the first of many rises as the bank moves from stimulating the economy to fighting inflation.

“The board is committed to doing what is necessary to ensure that inflation in Australia returns to target over time. This will require a further lift in interest rates over the period ahead,’’ the RBA board said in its statement.

The statement also made it clear that they will continue to focus on the strength of inflation, the jobs market – particularly unemployment and wages growth – and also economic growth.

Almost entirely gone is the focus on stimulating the economy, which was a single-minded approach during the early days of the COVID-19 pandemic, and led to some unconventional policies.

Changes will be small and gradual

Both the fact that the rise was 25 basis points to take the cash rate to 0.35% and the language of the board statement made it clear that this rising interest rate phase will not be a panicked one.

While the rise in inflation to 5.1% and well above the RBA’s target range was perhaps higher than expected and is anticipated to lead to an estimated “top” of 6%, the reversion to a more neutral setting will be small and gradual rises, with the temperature of the economy carefully taken after each rise.

Should unemployment turn upwards, wages growth slow or the overall economy stumble, expect to see the RBA hold fire and wait before proceeding further.

The bank’s task is ironically helped by Australia’s large mountain of personal debt and particularly housing debt, with small rises enough to weigh heavily on those paying back the debts, and reduce demand in the economy quite quickly.

Banks will line up like the cavalry

If this initial rise has taught us anything, it is that the commercial banks will line up like soldiers to pass on the rises.

While there was a little bit of jostling and tardy behaviour by the banks in passing on savings on the way down, there will be none of that on the way up, and customers should expect the rises to be passed on in full to their variable rate loans very quickly.

If there is some variation, it is more likely to happen on the term deposit side of the equation, with banks starting to get used to the idea of competing for funds after years of being able to attract deposits with minimal effort and tiny rates of interest.

Monetary policy to be tightened in other ways

While it went largely unremarked on in much of the financial media, the RBA is also taking an unhurried approach in shrinking its balance sheet back to a more conventional size.

Dr Lowe was quite specific in saying that the bank was not going to start selling the bonds it bought during the pandemic.

Instead, the RBA is taking a more nuanced approach, planning not to reinvest the proceeds of maturing government bonds it owns and to let bond maturity dates naturally shrink the balance sheet over a lengthy amount of time.

It is important to note that even though the average Australian would be totally unaware of this process, it is effectively a tightening of monetary policy quite apart from manipulating the cash rate higher.

Predicting rates will not be too hard

Along with the rise in the cash rate, the RBA ushered in its new forecast for inflation, which is now expected to hit 6% as a headline figure and an underlying 4.75% this year before moderating to 3% by the middle of 2024.

Those with long memories might recall that 2024 was the RBA’s original estimate of when it would start raising rates again – a forecast that was rendered obsolete by the arrival of significant inflation both here and in much of the rest of the world late last year.

By giving us its main forecast for inflation, the RBA has effectively handed us the tools to keep an eye on how the numbers are progressing.

Should inflation rise above its projected peak of 6% then the outlook for rates would worsen. But, any sign that inflation is easing due to freeing up of supply lines or other factors in the lead up to 2024 would signal a pause in rate rises.

To this must be added the variables around unemployment, wages growth and economic growth but as a ready reckoner for how the RBA will implement its normalisation of interest rates, the inflation rate will act as a handy shorthand.