How will the economy cope as rates move higher? A SmartCompany Q&A

The Reserve Bank’s latest rate rise should send a clear message to entrepreneurs and executives: interest rates are only heading in one direction.

Yesterday’s 25-basis-point rise takes the official cash rate to 4.25% and is the fifth rate rise in the past seven months (including January, when the RBA board doesn’t meet). The major banks were quick to step in and lift their rates to around 7%.

The RBA’s actions suggest it believes that businesses and households have taken the previous rate rises in their stride.

But if rates keep climbing, what will the impact on the economy be? Time for a SmartCompany Q&A.

Another month, another rate rise. How many more hikes are we expecting?

The statement from RBA Governor Glenn Stevens said yesterday’s hike was a “step in the process” of getting rates back to “average” levels, which economists have taken as a signal that the RBA will drop its process of raising rates gradually in favour of some quick rises.

Exactly what that “average” level is, and how many more rate rises will be needed to get there, remains a bone of contention among economists.

While Westpac’s chief economist Bill Evans expects another rate rise in May, he expects the RBA will pause at 4.5%, perhaps for the rest of the year.

ANZ chief economist Warren Hogan on the other hand expects the RBA to remain on hold until July and is tipping rates will be at 5% by the end of the year.

The 5% end-of-year target seems to be the consensus of the market, too.

That would mean three more rate hikes, wouldn’t it?

Unless the RBA decides to hike by 50 basis points in May, June or July, which is unlikely.

The RBA seems pretty worried about the housing market. Will three more rate rises solve that problem?

The RBA certainly hopes so. The buoyant – some would say overheated – housing market was mentioned again by the RBA as a key reason behind the decision to raise rates, so it’s a fair assumption that the RBA is hoping its series of hikes will cool the market.

Will that happen? That’s not clear. Auction clearance rate, house prices and comments from property experts suggest the market has taken the previous rate rises in its stride, but the high levels of debt (most of which is related to property) carried by Australian households suggests higher rates will eventually have to bite.

Surely higher rates will start to force households to curb their spending?

That’s true, higher rates will eventually have an impact on consumer spending. And we might be getting close to that happening.

Bill Evans has been pointing out that consumer sentiment crashed by a massive 15.5% in March 2005 when the variable mortgage rate was increased to 7.3% from 7.05%.

Mortgage rates are currently hovering just under those levels now, so another rate rise could take the wind out of consumers’ sails.

What about business? How will higher rates impact them?

As is traditional after a rate rise, small business lobby groups including the Council of Small Business of Australia, the Australian Chamber of Commerce and Industry and the Australian Retailers Association have been quick to criticise the latest rate hike.

While these groups do run the risk of sounding a little like a broken record, it is worth pointing out that the idea that business is suddenly soaring thanks to the recovery is a little off the mark. Yes, the mining and resources sectors are doing very well, but these lobby groups rightly argue that conditions remain very patchy.

Credit remains tight and expensive, and rate rises will increase borrowing costs further.

The only consolation is that the credit squeeze should ease as the recovery takes hold and higher sales and profits will make it easier for SMEs to absorb higher rates.

So we need to be aware that rising rates could take a little steam out of the recovery in the coming months. That’s great, I was just starting to feel properly confident again.

Hang on, don’t get all down on us. Rising rates are a signal that the economy is getting back to normal after what was a pretty ugly period in 2008-09.

And we do need a little bit of historical perspective. While nobody likes the idea that rates are headed back towards 5%, we need to remember that the Australian economy survived with rates above 5% from November 2003 to November 2008 – in fact, this was a boom time for the Australian economy.

Businesses and households can cope with a few more rate hikes – we all just need to adjust.