Braced for rate rise? Steel for two

The economy recorded its biggest contraction in 20 years in the March quarter, yet economists say interest rates could rise as early as this week. What gives?

INTEREST rates are going higher, and soon. It could be this week, it might be in a month, or maybe the month after that, but they are going up. You can bank on it, economists say.

Talk to practically anyone paid to predict these things right now and they will tell you to expect at least one interest rate rise before the year is out - most likely two.

Two would take the cash rate from 4.75 per cent to 5.25 per cent, adding 0.5 percentage points to your variable home mortgage rate. Some, such as Deutsche Bank chief economist Adam Boyton, expect the Reserve Bank to move on rates as early as this week after the central bank's meeting on Tuesday (the news will be announced on Wednesday morning).

ANZ chief economist Warren Hogan doesn't rule this out but suggests July is more likely.

Commonwealth Bank senior economist John Peters is looking for a move after the August meeting. Either way, all three expect rates are headed higher, and soon.

Incidentally, CommBank's Mr Peters is looking for two rises before the end of the year and another two in 2012. If he's right, you need to start factoring the impact of a one percentage point increase in your variable mortgage rate reasonably soon.

Deutsche's Mr Boyton's call could be seen as gutsy given last week's unexpectedly high 1.2 per cent GDP contraction for the March quarter. But he says this news didn't change the underlying economic story at the macro level. His argument is that while the contraction was sharp, the bounce-back from it will be equally so. ''A lot of people have looked at the economy in an optically different fashion following the 1.2 per cent decline in the GDP, and it does create a bit of a communication challenge for the Reserve Bank. But that's a communication issue rather than an economic issue - fundamentally the big picture hasn't changed.''

Mr Boyton says the Reserve has also established a record of moving on rates at unexpected times in recent years.

Remember the rate increase during the election campaign in November 2007 and the lift last November following a low reading on inflation? So while he admits he's in the minority - a Bloomberg survey of economists says five expect rates to move higher this week, against 23 who don't - Mr Boyton is sticking with it.

''The Reserve has to set policy for the average and the reality is we have strong business investment at a time when we are at close to full employment, so other parts of the economy will have to grow at below average to accommodate this.''

ANZ's Warren Hogan agrees. He says this is the key reason why interest rates need to rise even though big parts of the economy are already struggling. ''We need to get one in pretty quickly so we are set for a significant surge in mining investment, building and construction,'' he says. ''It's a problem we have in Australia; we have very little spare capacity, particularly in the labour market, just as we are heading into a big push-up in investment.''

This is not a short-term issue, either, according to Mr Hogan. ''It's the reality of the Australian economy in the next three to five years - some sectors will do it tough.''

CommBank's Mr Peters says consumers have done their bit by being cautious and well behaved - using 11.5 per cent of their income to pay down debt, a rate not seen since the early 1970s, controlling spending and putting money into term deposits so that the banking sector doesn't need as much expensive offshore borrowing for local home mortgages.

''Even in the first quarter, the domestic demand side was still strong, growing 3.3 per cent in annual terms,'' Mr Peters says.

''But this mining investment boom is going to keep going, and the rest of the economy has got to make room for it.''

Story by Richard Webb http://www.smh.com.au