Interest rates, inflation and the RBA

Interest rates, inflation, the RBA and how it all works

by Verve

We get it, the lettuce at your local grocer costs $6, you’ve seen Phillip Lowe (the older gentleman with glasses i.e. The Governor of the Reserve Bank of Australia) on your tv most nights, and now you’re hearing mortgages will increase.

Below we cover interest rates, inflation, the RBA and how it all works.

For beginners and for those of us who maybe understand how these things are related, but couldn’t quite add an opinion confidently at the family dinner table. Here is the five-minute lesson on modern monetary policy.

Firstly, why does Phillip Lowe and the Reserve Bank of Australia (RBA) care about the price of lettuce?

Ok, so technically speaking the price of lettuce isn’t the RBA’s focus of attention.

But they do focus on inflation overall, which is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. Mostly, they are concerned about:

  1. Price stability: Inflation can erode the purchasing power of money, which means that people can buy fewer goods and services with the same amount of money. This can lead to uncertainty and can make it difficult for households and businesses to make long-term financial plans. By maintaining low and stable inflation, the RBA aims to provide a stable economic environment that helps households and businesses make informed financial decisions.
  2. Economic growth: Moderate inflation can be beneficial for economic growth, as it can encourage spending and investment. However, high or volatile inflation can have negative impacts on the economy, as it can discourage spending and investment and can lead to financial instability. The RBA aims to maintain a balance between supporting economic growth and keeping inflation low and stable.

So where does the RBA want inflation, and where is it at?

The RBA seeks to achieve an inflation rate of 2-3% per year, on average, over the medium term. This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community.

The RBA’s inflation target is based on the Consumer Price Index (CPI), which is a measure of the price of basic goods and services consumed by households.

It is important to note that the RBA’s inflation target is not a ceiling or a floor, and the actual rate of inflation can vary from the target range for a variety of reasons.However, according to the Australian Bureau of Statistics , the monthly CPI indicator rose 8.4 per cent in the 12 months to December 2022 – well above the target level.

Ok, so high inflation is bad, what’s that got to do with interest rates?

The RBA uses a number of tools, including interest rates, to manage inflation. If inflation is high, the RBA may increase interest rates to try to reduce demand and bring down prices.

Conversely, if inflation is low, the RBA may lower interest rates to try to stimulate demand and increase prices.

But how does lifting interest rates impact inflation?

Higher interest rates make borrowing more expensive, which can discourage people and businesses from taking out loans and spending money. This can help reduce demand for goods and services, which can in turn help reduce inflation.

So how does the RBA practically lift interest rates? Aren’t interest rates determined by banks and other financial institutions?

The RBA is responsible for setting the official cash rate, which is the interest rate at which banks and other financial institutions lend and borrow money overnight. The RBA uses the official cash rate as a tool to influence the level of demand in the economy and to manage inflation.

To increase interest rates, the RBA can take the following actions:

  1. Raise the official cash rate: The RBA can increase the official cash rate by announcing a higher rate at its monthly meetings. In response, banks and other financial institutions lend money at a higher rate, which can help to reduce demand and bring down prices.
  2. Sell government bonds: The RBA can sell government bonds to financial institutions, which reduces the amount of money available for lending. This can increase the cost of borrowing and can help to reduce demand and bring down prices.
  3. Use other monetary policy tools: The RBA can also use other monetary policy tools, such as the term lending facility and the domestic market operations, to influence the supply and demand of money in the economy.

So, will interest rates keep rising in Australia in 2023?

It’s impossible to predict with certainty what will happen to interest rates in 2023, however indicators are pointing to further rate rises.

The bank’s final meeting minutes for December 2022 reveal it is still concerned about higher spending over the summer holidays without Covid restrictions. The Governor has certainly put homeowners on notice.

This seems ridiculous; everything costs more, and now the government is lifting mortgage costs too. How is this a thing?

You’re not alone in asking this question, but it’s definitely a topic for another blog.. stay tuned.

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