Part two – Why are rates rising?
One of the main directives of the Reserve Bank of Australia (RBA) is to keep inflation within the target band of 2% to 3%. Generally speaking, they will increase the cash rate when inflation is too high and decrease it when inflation is too low. The idea is that higher interest rates increase the cost of money, meaning consumers and businesses borrow less and the money they borrowed costs them more, leading to less investment and spending, thus decreasing demand which leads to a reduction in prices. Decreasing rates puts this process in reverse. An important point to remember when thinking about monetary policy, specifically in regard to interest rates, is that there is a well-documented time lag between its implementation and effects. Just because interest rates rise, doesn’t mean everyone sells their house, businesses cancel their contracts or abandon their investment plans. This time lag is recognised to be 18 months to 2 years for the full effects of an interest rate rise to be felt.
Currently the RBA is increasing rates in part, to return interest rates to the pre-pandemic setting, which was marked by quantitative easing for the first time in the bank’s history. In addition, they are attempting to control inflation mentioned in part one of this series. They are in fine company with central banks around the world doing the same. Those of you paying attention may ask why, given that the causes of inflation currently are external to Australia. The answer is they are attempting to get ahead of wage growth in an uncertain climate of supply shocks. Indeed, it has been well recognised that the danger of the RBA going too hard on interest rates and pushing Australia into recession has been well noted. This has lead to growing speculation that interest rates will need to be cut again before the end of 2023. Along with this is increasing questioning of RBA’s performance, leading to a federal government review of the RBA and the targeting of inflation with monetary policy. Indeed, if the RBA has gone too hard, we could be in for an interesting 18 months as the aggressive hikes of the last few months continue to make their full impact throughout the economy.