What if interest rates double?

Over the past few months I have been asked whether the Reserve Bank of Australia (RBA) will lower interest rates by 25 basis points in the coming months.

My answer: Who cares?

With a RBA cash rate so low, does it matter that much if we see a rate cut of 25 basis points? Oh sorry, it might save borrowers $25 more per month. If your hoping for such a rate cut to save you $300 per year, perhaps you are too leveraged in the first place and didn’t do anything about it over the past three years?

The real damage will be done if rates were to double or triple over the next 8-12 years, of which I am placing a greater probability towards occurring.

The Australian inflation rate was last reported as 3.5% and the RBA’s “Cash Rate” is 4.25%, which equals a real interest rate of 0.75%.

Investors in Australia, today, need to re-educate themselves about the differences between a nominal interest rate and a real interest rate.

Earning 4.8% at-call in the bank, isn’t REALLY maintaining your purchasing power when you include the inflation rate, let alone adjusting for taxes!

What if……due to various global capital forces, the real interest rate rose 1.5%, which would be closer a 30 year average and when combining my view of prolonged energy and food inflation AND the economic effect of expanded money circulation, inflation rates could themselves rise a further 2%.

Hey presto! You would then have an inflation rate of 5.5% plus a real rate of 2.25% for a nominal rate total of 7.75%.

Add the spread that a lending bank would charge and you are suddenly borrowing money at 10.2%!!!

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