Interest rate forecast: what’s ahead?

| August 24, 2011

To set interest rates, inflation takes centre stage. The Reserve Bank (RBA) primarily focuses on inflationary pressures. Then, to a lesser extent, it focuses on asset prices and forward indicators of inflation, such as labour costs and the strength of activity and labour markets.

“The RBA is particularly concerned that the labour market is tightening and will result in higher wages,” explains NAB’s Chief Economist, Alan Oster. “Also, it expects a strong bounce in activity as Queensland recovers [from natural disasters] and the mining boom kicks in.”

Special factors, such as extreme weather, are taken into account, says Oster, and the RBA will also be mindful that prices for goods may temporarily rise as supply temporarily drops off. He notes a prime example is this year’s Queensland floods and the resulting spike in banana prices.

Although Australia’s inflation band is set at 2–3 per cent for the next 12 to 18 months, Oster points out that inflation can comfortably go above or below that band for the short term, provided there’s a real expectation that it returns to within 2–3 per cent in the medium term.

Rate rise drivers for 2011
NAB predicts an RBA rate rise of 25 basis points before the year is out, possibly in December, with another rate rise tipped for around mid-2012. These rises, when they do occur, will reflect the RBA’s concerns about inflation in the face of accelerating, if uneven, growth.

Economic growth is likely to accelerate for the latter half of 2011 due to significant investment in the mining sector, post-flood rebuilding of Queensland and a resurgence in coal mining. Accordingly, the RBA will seek to curb growth while inflationary pressure mounts and as the prices of wages, fruit and vegetables, oil and utilities all rise. In particular, the RBA doesn’t want to see these factors feeding into higher wage expectations.

Work rates will also play a role in rate levels, with the current 4.9 per cent unemployment rate triggering concern that wages will increase strongly.

Loans advice for SMEs
As an SME operator looking to expand and/or firm up a superannuation nest egg, approach interest rates cautiously when borrowing funds. “Always allow for the possibility of an interest rate increase in the pipeline,” warns Oster. “Plan on that basis and be flexible in terms of your financing: have some variable and some fixed rates in your loans.”

Sector by sector
Rate rises are determined by the economy as a whole, not on the performance of just one star sector.

“It’s a multi-speed economy, so, for instance, in mining and in manufacturing related to mining, the economy is booming but in retail, it’s probably as bad as during the GFC,” says Oster. “General manufacturing is lagging, as is construction outside of the mining realm. Meanwhile, legal and accounting sectors are faring pretty well, road transport and inbound tourism are experiencing slow growth but outbound tourism is strong.”

Within the public sector, the multi-speed economy and the direct cost of the floods have reduced government revenue. The large carry-forward losses from the GFC also continue to be a factor. “Broadly, the government has allowed reduced revenue to flow through to larger near-term fiscal deficits,” says Oster. “But then it moderately tightened policy in order to help return the Budget to surplus by 2012/13.”

Mortgage risk mitigation
In terms of interest rates and mortgages, Oster anticipates increases of another 50 basis points.

“SMEs need to be financially prepared for that possibility,” he says. “In terms of varying between fixed and variable, it’s always useful to have a mix of both. But it’s an individual decision. A variable loan is good in that it’s related to the cash rate and has lots of flexibility. A fixed loan allows you, essentially, to sleep at night because you know what your rates are, but if you need cash flow quickly and have to pay that loan out, there are exit penalty costs involved.

“Talk to your financial adviser and consider a quarterly review to find out what financial opportunities are available for your SME – when it comes to the economy, things move quickly and you need to keep your business plan current.”

For more interest rate analysis, watch the NAB Round Up Report.

This story was first published at NAB Business View Connect and is republished here with kind permission of the author.