Tuesday, November 07, 2006

Why rates need to go up to stay low

From tomorrow's Canberra times:.

The Prime Minister has called for understanding ahead of what is expected to be Australia’s eighth consecutive interest rate hike.

It is thought the Reserve Bank will lift its so-called cash rate target by 0.25 per cent today to 6.25 per cent, pushing the standard bank variable mortgage rate up to 8.05 per cent.

But most new customers of banks don’t pay that standard rate. The Reserve Bank says the actual rate paid by new borrowers is typically 0.6 per cent less, a rate of 7.45 per cent after this morning’s expected hike. And some mortgage providers charge even less. Homepath, owned by the Commonwealth Bank is expected to charge only 7.21 per cent after this morning’s hike.

Nevertheless the repayment burden on a typical mortgage has climbed to an all time and will climb further. Reserve Bank figures show that the proportion of household disposable income eaten up by mortgage interest payments is now half as high again as it was in the late 1980’s when interest rates peaked at 17 per cent under Prime Minister Bob Hawke.

Prime Minister John Howard said yesterday that if the Bank puts up interest rates as expected today “I will say that I never like to see rates go up, but sometimes in the name of good longer term economic management it is necessary, especially when the economy is running very strongly, it is necessary for the central bank to act rather than sit on its hands. I would say to everybody that if the bank were to sit on its hands and do nothing then the pain of adjustment later on would be much greater.”

Opinion in the Bank firmed in favour of a rate rise a fortnight ago with the release of figures showing the headline rate of inflation stuck at around 4 per cent. The Bank’s target is 2 – 3 per cent. Its recently appointed Governor Glenn Stevens said in his first speech in the job last month that that he saw his main task as being to “see off the higher inflation of the past year or so”.

In September his predecessor Ian Macfarlane described the process of setting rates as an amalgam of an art and a science. “If you read a lot of academic treatises on economic policy, you would think that we have a big econometric model, and that we turn the handle on that, and that determined what we did. That is certainly not the case, I don’t really place very much credence at all on economic models, but it is based on an awful lot of empirical evidence and experience and analysis of previous business cycles and economic theory and common sense, and skepticism,” he told ABC Radio.

Mr Macfarlane said the question he asked himself when deciding whether or to not to adjust rates was: “When I look back in two years time, what could be the biggest mistake that I can identify being made now”. He said he tried to act to avoid that mistake.

The mistake that Reserve Bank officials are worried about making at the moment is allowing inflation to become entrenched at a level too high to bring down easily later. With employment and the use of infrastructure at generational highs there is a risk that unchecked, inflation will stay beyond the Bank’s target band and climb.

Glenn Stephens said in his previous role as Deputy Governor earlier this year that “thoughtful people understand that the way to keep inflation and interest rates low on average is to be prepared to put rates up modestly, but promptly, when inflation pressures start to increase.”

The members of the Reserve Bank Board met in the boardroom above Sydney’s Martin Place at 9.30am yesterday and considered a four to five page overview of the economy sent to them by the Bank’s management at the end of last week. Among those present were the Secretary to the Treasury Ken Henry, the ANU econometrician and climate change specialist Warwick McKibbin, the former head of Woolworths Roger Corbett, and the Chairman of Telstra Donald McGauchie.

The Bank’s previous Governor Ian Macfarlane has said that in his decade in the job the Board never rejected one of his recommendations. The announcement is expected at 9.30am.

It will bring Australian general level of interest rates back to where it was at the start of the decade before the series of interest rate cuts that began in 2001. But paying off a mortgage will be much more difficult than it was then because the size of a typical mortgage has grown much bigger.

When reminded yesterday that he had delivered his 2004 election policy speech from a lectern emblazoned with a sign that read ‘Keeping Rates Low’ Mr Howard said “even if rates go up tomorrow by a 0.25 per cent, they will still be low. They will be for housing somewhere in the order of 7.75 per cent, compared with a peak of 17 per cent under Mr Keating. So that sign will still be correct."