The Reserve Bank of Australia (RBA) has recently been increasing its cash rate target. The first increase was 0.25% at its May meeting. It then followed this up with another 0.5% increase in June. The cash rate has increased from 0.1% to 0.85% and the RBA announced that it would no longer reinvest proceeds of maturing government bonds. The RBA now believes that the Australian economy no longer needs extraordinary policy settings.
Why has the RBA increased interest rates?
For much of the pandemic period, the RBA indicated that it was unlikely to raise interest rates until 2024. This view was based on an outlook where the economic recovery from the pandemic was expected to be much slower than has occurred. In particular, the RBA had a view that inflation would remain low.
The chart below shows that underlying Australian inflation has increased materially over recent quarters from 1.1% in the March quarter 2021 to 3.7% in March quarter 2022. Importantly, the latest outcome is outside the RBA’s 2 to 3% target range and was much higher than the RBA anticipated. Along with the high inflation outcome, the very low unemployment rate of 3.9% has prompted the RBA to re-think its inflation outlook and monetary policy. This resulted in the recent increases in the cash rate.
Interest rates are rising globally, with other central banks such as the US Federal Reserve and the Bank of England raising their cash rates recently. Like the RBA, these central banks have been surprised by the level of inflation in their countries and are expecting to increase their cash rates much faster than they previously anticipated.
How much will the cash rate increase?
It is difficult to know how much the cash rate will rise. That said, a material increase looks likely over the next 12 months. The rate is currently very low versus the level of underlying inflation (0.85% versus 3.7%) and the RBA is keen to bring inflation under control. The chart below shows the 2-year bond yield, which provides some broad guidance on the extent to which the market expects the cash rate to increase. The market is expecting the cash rate to rise to around 3% by the end of this year.
The recent increase in the cash rate marks an important change in the Australian economic environment, particularly for those people who have borrowed to buy a house or apartment. We expect further cash rate increases during the remainder of this year as the RBA tries to bring inflation down from above its 2 to 3% target. We anticipate that this will result in weaker housing activity and lower house prices over the next 12 to 18 months.
The higher Australian cash rate is expected to increase the returns from Vision Super’s Cash option. The direct impact of higher cash returns on other investment options is generally not expected to be material as most have low allocations to the cash asset class.
Rising interest rates have had an adverse impact on a range of asset classes in 2022 so far, including some defensive asset classes. We anticipate that weaker growth as a result of higher interest rates will provide a material headwind for shares over the next 12 months.
Investment returns are not guaranteed. Past performance is not a reliable indicator of future returns. This information is general advice which does not take into account your personal financial objectives, situation or needs. Before making a decision about Vision Super, you should think about your financial requirements and consider the relevant Product Disclosure Statement and Target Market Determination issued by Vision Super Pty Ltd ABN 50 082 924 561 AFSL 225054 at www.visionsuper.com.au