How high will interest rates go? A SmartCompany Q&A

The Reserve Bank’s decision to leave the official cash rate on hold yesterday means that Australian business owners should start to prepare themselves for an interest rate rise.

But when will it happen, and how high could rates get in the next 12 to 18 months?

Time for a quick SmartCompany Q&A.

So it’s over. No more rate cuts.

I’m afraid that’s right. In many ways, it wasn’t the RBA’s decision to leave rates on hold yesterday that was significant, but rather a subtle change in the language in the accompanying statement from RBA Governor Glenn Stevens.

For the best part of a year, Stevens’ statement has included a phrase indicating the RBA had “scope for further easing” of interest rates. That statement was missing from yesterday’s statement, a clear signal that rates won’t be falling any further.

Isn’t that a bit premature? Things are looking better, but I keep hearing this cliché about us not being out of the woods yet.

The RBA has clearly decided that we are on the verge of recovery and it has even started to get worried about the possibility of inflation, particularly in the area of house prices, which jumped 4.2% in the June quarter according to data released by the Australian Bureau of Statistic. At the first sign of inflation, Stevens will want to lift rates.

Even if unemployment is still rising?

Yes, it appears so. A number of economists, including Westpac’s chief economist Bill Evans, points out that lifting rates before unemployment has peaked would be very unusual, but it appears a near certainty.

Most forecasters (including the Federal Government) are not predicting unemployment to peak until late 2010 or early 2011, but most forecasters are also tipping that rates will be rising by then.

How soon might the RBA hike?

Tough question – ask 10 different economists and you’ll get 10 different answers. Most forecasters (and ANZ and Westpac are included here) are tipping the RBA will leave rates on hold until well into 2010; Westpac expects two modest hikes of 25-basis points each in late 2010.

But other economists are expecting rates to rise much sooner. Some are tipping early 2010, while others, including Citigroup’s chief economist Paul Brennan, are tipping a rise of 25-basis points before Christmas.

Yikes, that’s soon. How high will rates get?

Another tough question. Brennan is tipping rates will be at 5.5% by the end of 2010, which would mean a 2.5% rise in the space of just over 12 months.

Are you serious?

It does sound unlikely, particularly given the state of the global economy, but it is possible given that the RBA did slash rates by 4.25% between September 2008 and April this year.

What would force the RBA to lift rates so quickly?

It seems Stevens’ biggest fear is the housing bubble. The Government’s stimulus handouts and the enlarged First Home Owners Grant have helped keep the property market buoyant despite the downturn and Stevens is clearly worried that the housing sector may become overheated as the broader economy recovers and investors re-enter the market.

Of course, there is a bright side to all this talk of rate rises – it means the economy is about to enter recovery mode.

And that can’t be bad news.