Why rate rises can be good news

THE great interest rate debate is on in earnest.

In many ways this is a good thing – a tangible and positive sign of economic and market conditions returning to operating within more normal bands.

Record low interest rates sound terrific and something we should try and hang on to but the reality is that keeping interest rates too low for too long brings its own set of risks in terms of inflation and overheated asset prices. Indeed some US commentators argue that low interest rates were a key contributor to the global financial crisis.

Record low rates of course help some parts of the community – people with mortgages the most obvious – but hurt others like retirees looking to earn income off their investments without taking significant market risk.

This week’s appearance by the Reserve Bank governor Glenn Stevens before a Senate inquiry was always going to set the political hares running on the outlook for interest rates. After all the inquiry is looking at whether the stimulus package should be reined in sooner rather than later given Australia’s better than expected economic and budget performance.

We should expect regular instalments in the political side show until the Reserve Bank finally lifts interest rates. The key point here is that it is not a matter of “if” interest rates will rise but “when” – with the pundits split between early moves in November or later in February.

The fact the debate has got to this point is heartening in itself. Glenn Stevens and the Reserve Bank probably categorise this as a nice problem to have. Cast your mind back to a year ago – a rise in interest rates was unthinkable as we watched the world’s global economies hit the brakes and governments were forced to step in around the world to provide much-needed stimulus and systemic support.

So the fact we are talking about and expecting rates to rise is a reminder that the global economy and financial system has weathered the severest of storms and now central banks are looking forward to ensure they manage the next leg of the recovery cycle appropriately.

Coincidentally another piece of Reserve Bank data and commentary underlined the risks we may be exposed to by keeping interest rates too low for too long.

Firstly the RBA data on first home loans showed that first home buyers were not just responding to the government incentive package by applying for loans in higher than normal numbers but that they were taking out much bigger loans.

Figures provided by the Australian Bureau of Statistics show the average first home buyer is signing up for mortgage debt that is higher than the market average.

The concern here is that in the rush to take advantage of the government’s incentive first home buyers are putting themselves at risk of severe financial stress once loan rates rise in the near future.

Perhaps this is a short term aberration because the incentive is ending but it would be a sad outcome if the most vulnerable borrowers were caught out by rate rises that are trying to dampen down house price inflation that the incentive has driven.

* Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia. To receive this column by email each week go to www.vanguard.com.au and register with smart investing.


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