Economic shorts: watching rates, inflation

The “great shift” in interest rates has begun, globally and in Australia. But what does that actually mean?

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The Reserve Bank of Australia (RBA) is Australia’s central bank and is responsible for monetary policy. It sets the target for the overnight cash rate, the rate at which commercial banks borrow money from the central bank, the “official” rate on which everyone focusses.

“In many countries, inflation has risen sharply and is historically high. If inflation is too high, raising interest rates will help to bring it back down.”

The cash rate influences other interest rates in the economy, including lending and deposit rates for households and businesses. When the cash rate goes up, other interest rates go up as well - including any variable business loans, personal loans or home loans. Fixed rates move as interest rates move as well but they change based on a mix of the current cash rate and expectations about what the cash rate will be in the future.

All these interest rates in turn influence economic activity, employment and inflation.

The lower the cash rate and other interest rates, the cheaper it is to borrow money because there is less interest to pay. However, less interest is also received when you save money. Lower rates mean the cost of using savings or borrowing money to buy things, expand a business or hire an extra worker has less of a downside.

This helps stimulate economic activity because people are incentivised to buy and spend more. It can also reduce unemployment because saving extra money by not hiring an extra worker has less of an upside when the cash rate is lower and you can borrow more to expand your business without much cost when the interest you pay on debt is lower.

On the flip side, if rates are increased it makes it riskier to spend money, expand a business or hire someone, because more interest is lost from using savings. Or more interest is paid when debt is taken on.

Passed on

Lower interest rates can also raise inflation. This happens in a few ways. One way is when the lower cash rate reduces unemployment and workers are given more power to ask for a pay rise. If there are very few unemployed people then a business might need to work harder to attract the right person to their business - and might have to pay more to get them. They may also have to give existing workers more money so they don’t get lured elsewhere.

Some of the extra money the business pays workers might get “passed on” via higher prices. And just as businesses have to work harder to keep their employees when rates are low, they have to work “less hard” to keep their customers.

When rates are lower,  it easier for customers to borrow or spend more money and the increase in prices affects them less when they aren’t paying much on their loans or receiving much on their savings.

For example, if you lose $A10 interest by taking money out of your savings to buy a new item, then the “real cost” of the item is the price + $A10. But if you only lose $A1 interest, the “real cost” is the price + $A1. So if the price went up a dollar or two, you still might buy the product.

In many countries, inflation has risen sharply and is historically high. If inflation is too high, raising interest rates will help to bring it back down. Raising interest rates essentially forces many businesses and households to think twice about rapid spending and hiring behaviour, which in turn slows down price pressures and inflation.

This is the main reason several central banks around the world are already lifting their rates, including the Reserve Bank of New Zealand, the US Federal Reserve, the Bank of Canada, the Bank of England and the Bank of Korea.

Next steps

In Australia, inflation is also rising but it is still lower than in many other countries. This is one reason the RBA has moved more slowly. Though, with inflation reaching 5.1 per cent year-on-year in the latest data, this has put more pressure on the RBA to manage rates higher.

ANZ Research expects the RBA to lift the cash rate to 1.25 per cent by the end of 2022 and 2.25 per cent by May 2023. By the peak of the cycle around the mid-2020s, we could see a cash rate of 3 per cent or above. This would be the highest since at least 2013.

For borrowers, such as households with mortgages, rising interest rates can feel like a bad thing as they may pay more interest on their debt, reducing the income they can spend on other things or save.

But when the cash rate is rising it means the overall economy is doing well. Households and businesses are spending and investing more, more people are employed and they’re seeing their wages rise.

It’s also a good thing for savers because they get a higher return on their savings.

There is some concern that if the cash rate gets this high, causing mortgage rates to increase significantly, many households will not be able to keep up with their mortgage repayments and may default on their loan.

But based on ANZ Research’s forecasts, household interest payments as a share of income should still be similar to the pre-pandemic level by the end of 2023.

And the substantial savings that households have built up during the pandemic puts them in a much stronger financial position to weather future rate rises.

Adelaide Timbrell and Catherine Birch are Senior Economists at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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