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Effect of Inflation and Credit Availability on Interest Rates

Posted By Ivan Mantelli on January 21, 2008 No Comments » Filed under: Banking Industry, Economics and Interest Rates, Mortages and Home Loans

Interest rates in Australia have been increasing for some time now and in our view are likely to rise a little further yet. There are a number of factors that have driven the increase in the underlying cash rate to 6.75% (the Reserve Banks principle tool for affecting the future inflation rate) and also the recent increases in home loan and personal loan interest rates offered by the large financial institutions (such as the Commonwealth bank, Westpac, Wizard  etc).

The principle factors are:

  • Inflation and the economy are cyclic
  • The ‘credit crunch’ following on from the collapse of the US sub-prime market
  • Strong economic growth in Australia and globally

The economy and inflation and as a result interest rates are typically cyclic and follow a long-term pattern that results in a variance around a mean interest rate of about 7%. We recently experienced low interest rate and low inflation rate times in the late 1990s that followed extremely high interest rates in the late 1980s. The low interest rate environment helped fule Australia’s housing boom that helped push housing up and simultaneously increased the cost of living that is then reflected in higher inflation. In an attempt to restrain inflation the RBA (Reserve Bank of Australia) has increased the underlying cash rate to make borrowing more expensive.

The impact of inflation and high interest rates is important as it tends to inhibit business growth and consumer spending (an important driver of the Australian economy) as we have today seen Kevin Rudd and the Labor Government seeking to reduce the 2008 budget by $5 billion to help keep inflation under control (higher Government spending tends to increase inflationary pressures).

The recent strength of the Australian (and global) economy has driven wage and other price increases that in turn pushes up inflation, in particular the mining and resources boom has led to a shortage of skilled specialists with high wage premiums required to attract suitable candidates. It is likely that the strength of the Australian economy will continue for a while (even though a US recession is looming which may impact consumer sentiment and spending).

The Global ‘Credit Crunch’

The collapse in the US subprime home loan market has created both illiquidity and higher rates for financial institutions, corporations and other large scale lenders and borrowers that is being directly passed onto borrowers and consumers. It is now much harder for companies to raise debt globally to fund business expansion and business activities (a case in point being the fall in investor confidence in Centro and Allco and the uncertainty around the RAMS Home Loans business and its ability to refinance a significant part of its home loan book).  Banks have experienced a higher cost to raise money which is now reflected in 8%-9% home loan interest rates and even higher personal loan rates.

What can consumers and borrowers do to minimise their credit and financing costs? Whilst the market sets the interest rates there is a great deal of variance amongst the banks, credit unions and non-bank lenders. Borrowers should shop around and compare rates for at least 3-4 lenders. It is times like these that consumers are often able to find comparative bargains just through a little legwork.

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