Are interest rates in Australia set to jump? A SmartCompany Q&A

The decision by Commonwealth Bank to increase its variable mortgage rate on Friday has angered the Federal Government and consumer groups.

Up until that moment, economists and commentators were getting excited about the green shoots of economic recovery that were starting to emerge, but many have argued that rate rises could hold back any recovery.

So where are interest rates heading? Time for a SmartCompany Q&A.

So why exactly has Commonwealth Bank raised its rates?

CBA says it’s all to do with the cost of funding, which has soared since September last year when the credit crisis was in full swing.

But I thought the cost of funding has fallen since the economy started looking a bit better?

It has, but the problem is that the banks are rolling over funding secured at cheap, pre-crisis levels and are being forced to pay much more for funds in this post-crisis environment. So in order to protect their margins, variable loan rates are on the rise.

Terrific. Will the other banks follow suit?

Matthew Johnson, interest rate strategist at UBS, reckons they will, although Deputy Prime Minister Julia Gillard has pleaded with ANZ, Westpac and NAB not to automatically boost their rates too.

However, Westpac chief economist Bill Evans noted over the weekend that CBA’s rate has now increased to 5.74% – the same as NAB and HSBC and still lower than ANZ and Westpac which are currently at 5.81%.

Will CBA’s decision really slow our economic recovery?

That’s a tough one. As economists such as Craig James from Commsec have pointed out, interest rates are still at historically low levels, even with CBA’s small increase.

But it’s really a question of what this rate rise (and subsequent rises by the other banks, if they happen) will do to confidence. First home buyers have been storming into the market in recent months, providing a solid base for the housing market and helping the economy avoid a technical recession in the first three months of this year.

Will the psychology of these first home buyers be knocked around by this little rate rise? If so, that will represent an unwanted hurdle for economic growth.

Can the RBA step in and help out?

Up until last Friday, financial futures market were so optimistic about the prospect of economic recovery that they were predicting the next move by the RBA would be to increase interest rates in early 2010. But CBA’s rate rise is likely to change that forecast, particularly if other banks follow suit.

So with unemployment on the rise and recovery still some distance off, many economists believe the RBA is likely to cut rates again in the next few months. This would have the effect of reducing the cost of funding for the banks and allowing them to take their variable rates down again.

But exactly when the RBA might cut rates isn’t clear. We’ve had a lot of good economic news recently, so the Reserve might be tempted to watch how events unfold for a few more months.