So the Reserve Bank has raised interest rates for the fifth time this year. But why? Whatโs it trying to fix? And will it work?
These are matters of no little importance to those of us struggling to keep up with the cost of living. But theyโre also of concern to Anthony Albanese. Heโs a man whoโs taken little interest in the economy now being caught by the iron rule of politics: if the economy turns bad on your watch, you take the blame.
The Reserve has been surveying people to find out how much they know about the economy and what they think of its good self. Itโs been chuffed to learn that inflation is by far our greatest economic concern. Like all other central banks, the Reserve sees keeping the rate of inflation low as by far its most important role.
Although most people know the Reserve is responsible for keeping the rate of inflation low, the survey finding that would have worried it a lot was that only about a quarter of people (including those who read my column, I trust) believe that increasing interest rates will reduce inflation, whereas almost 60 per cent think it will make inflation worse.
So, just this once, letโs go back to basics. If you already knew what follows, give yourself a pat on the back.
The only lever the Reserve has to reduce inflation โ the rate at which prices across the economy are rising โ is to increase interest rates. All the rich-country central banks do the same. They all believe that, if you raise interest rates high enough, inflation will slow to an acceptable rate, which in Australia we regard as prices rising by just 2 to 3 per cent a year.
If youโve paid attention to all the times the Reserve has done this over the years, like all economists you will be in no doubt that it works โ in its own painful way. The Reserve controls what I call the โofficialโ interest rate but which is known to the experts as the โovernight cash rateโ โ the rate at which the banks lend to each other from one day to the next. The official interest rate sets the base for all other interest rates in the economy. The banks and other financial institutions add a margin to the official rate to cover the risk that they wonโt be repaid plus a profit margin to the rates they charge households and business borrowers.
So the Reserveโs increases or decreases in the official rate eventually flow through to all interest rates. Sometimes the flow-through is almost immediate, such as to home loans with variable interest rates, but will take longer for fixed-rate loans of 10 years or more.
Donโt forget that while an increase in the official rate allows the banks to increase their charges to borrowers, competition between the banks obliges them to increase the interest rates they pay to depositors. So remember โ as the media almost never does โ that increases in interest rates benefit savers.
Remember, too, that when high interest rates have done their job, the Reserve winds them back down.
I can remember, not too many years back, that every increase in the official interest rate would start a debate about how much of it the banks were likely to pass on to people with variable-rate mortgages and how long it would take. These days, a full flow-through to variable-rate mortgages is almost automatic.
But the Reserve has got tired of people like me always talking about the effect on people with mortgages and nothing else. As you can learn from its website, a rate rise affects the economy in four other ways.
First, an increase in interest rates eventually flows through to all forms of borrowing. So if you get a personal loan or a loan to pay off a car, the interest rate will increase โ if not on your present loan then on the next. Whether youโre borrowing for a home or just some big item, youโre left with less money to spend on other things.
Similarly, the interest rates charged on loans to businesses go up โ although the bite is reduced by business loans being tax-deductible.
Second, higher interest rates make it more attractive to save. And if people save more, they spend less.
Third, higher interest rates tend to lower the value of assets such as shares and houses. This makes people feel less wealthy and so less willing to spend.
Fourth, higher interest rates are likely to increase our dollarโs exchange rate โ allow it to be exchanged for more US dollars or other foreign currency. This makes imports cheaper, directly reducing their price for Australians.
All this is why people are wrong to think that raising interest rates will make inflation worse rather than better. Itโs true that higher rates will add to businessesโ costs, but this small adverse effect is overwhelmed by all the other effects that work to reduce the upward pressure on prices.
Hereโs the point. When it wants to reduce the rate of inflation, the Reserve increases interest rates so as to reduce our borrowing and spending. Itโs reducing our demand for (spending on) goods and services relative to the supply of them. This reduced demand makes it harder for businesses to put up their prices.
Iโm not sure Iโm convinced, but the Reserve believes itโs the rate risesโ effect on the value of our dollar that does more to get inflation down than the effect on people with big mortgages.
Does this sound simple and painless? It isnโt. It involves slowing the rate at which the economy is growing, which causes slower growth in employment and rising unemployment. If the Reserve miscalculates and slams on the interest rate brakes too hard, the economy goes into recession.
But not to worry. If that happens, it will be Albo and his government that get the sack.
Ross Gittins is the Heraldโs economics editor.
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