Episode #2 in our Inflation Trilogy: Why do reserve banks raise interest rates to remedy inflation?

_{Highlight segments:}

_{7.25 – Cate points out that pre-2022, Australia’s inflation was under the target band and Dave expands}

_{9.25 – Mike contemplates a new $100 note design}

_{10.38 – Cate recalls her Dad’s nervousness about her proposed debt back in 1997}

_{16.32 – Mike touches on the uncertainty that can be created when states and federal government start ‘tinkering’ around the edges}

_{22.00 – Dave explains why the target inflation band is 2% – 3%}

_{24.10 – Dave sheds light on some of the RBA open market operations}

_{25.27 – Mike gives his take on Quantitative Easing, aka “Money Printing”.}

_{29.25 – “Discount window lending”, and “forward guidance”, two concepts Dave shares}

_{37.09 – The Trio ponder the outcomes from rising rates}

_{44.40 – Gold Nuggets}

Cate hosts this this exciting second trilogy episode and the Trio enjoy working through some of the burning questions about the RBA and their responsibilities, actions and challenges.

1. What is the RBA’s mandate and how does it relate to inflation?

Dave kicks off with the answers.

FIrst, stability of the currency keeps Australia’s purchasing power optimised, and on par with other economies in the world.

Secondly, maintenance of full employment in Australia, “Everyone who wants a job, has a job,” states Dave.

And third is the economic prosperity and welfare of the people of Australia.

These responsibilities are within the RBA remit: 

• Monetary Policy: The RBA uses monetary policy tools, primarily through adjusting the official cash rate, which influences short-term interest rates and helps control inflation and support economic growth.

• Currency and Payments System: Issuing and managing the Australian dollar currency. It aims to maintain confidence in the currency and ensure the smooth functioning of the payments system, which involves overseeing the operation and stability of Australia’s financial infrastructure.

• Financial Stability: Promote the stability and resilience of the financial system. It monitors and assesses risks to financial stability, implements policies and regulations to address those risks, and collaborates with other regulatory bodies to ensure the overall stability of the financial sector.

• Economic Research and Analysis: Conduct economic research and analysis to gain insights into the Australian and global economy. This research informs the bank’s decision-making process regarding monetary policy and other areas of its mandate.

• Banking Services: Provides banking services to the Australian government, other financial institutions, and some international organisations. These services include managing the government’s bank accounts, issuing government debt, and facilitating the smooth functioning of the financial system.

2. Why do we need inflation? 

• Encourages Spending and Investment: Inflation can incentivise consumers and businesses to spend and invest rather than hoard cash. When people anticipate rising prices, they are more likely to make purchases and invest their money in assets or projects that have the potential to generate returns. This increased economic activity can stimulate demand, drive production, and contribute to economic growth.

• Supports Debt Repayment: Inflation can make it easier for borrowers to repay their debts. When there is inflation, the value of money decreases over time. As a result, borrowers can repay their debts with money that has less purchasing power compared to when they initially borrowed. This can provide relief to individuals and businesses burdened with debt obligations.

• Facilitates Wage Adjustments: Inflation can help in wage adjustments and maintaining labor market flexibility. As prices rise, wages tend to adjust to reflect the increased cost of living. This flexibility allows wages to respond to changes in supply and demand conditions in the labor market. It can help ensure that workers’ wages keep pace with the overall price level and maintain their purchasing power.

• Encourages Long-Term Investment: Inflation can incentivise long-term investment over short-term speculation. When inflation erodes the value of cash holdings, investors are more likely to invest in productive assets such as stocks, bonds, or real estate to preserve or grow their wealth. Long-term investments contribute to capital formation and can support economic development and productivity improvements.

• Provides Monetary Policy Flexibility: Inflation allows central banks to use monetary policy tools to manage the economy. By adjusting interest rates, central banks can influence borrowing costs, control money supply, and steer the economy towards desired outcomes such as price stability and sustainable growth. Inflation provides a reference point for central banks to set their policy rates and implement appropriate measures.

3. Why the target for inflation is set at 2-3 per cent?

A target range of 2-3 percent inflation is often considered a good target for central banks for several reasons:

Price Stability, Facilitates Monetary Policy, Avoids Deflationary Pressures, Supports Real Income Growth, and International Consistency. The trio ponder these various reasons and apply some relevant examples.

4. Why do we make cash rate adjustments?

Reducing the demand of goods and services in response to the spending that has pushed prices up at a fast rate. In addition, we are controlling the supply of money via bond management are two of the reasons, according to Dave.

Dave sheds light on some of the RBA open market operations, and makes the point that fiscal policy must work in tandem with monetary policy.

Mike shares with us all his explanation of Quantitative Easing, aka “Money Printing”. He demystifies this concept superbly by outlining the drivers for QE, the purpose of QE, and some of the outcomes of QE. The unintended consequences are something we need to consider and Cate presses Mike on this.

5. Outcomes from rising rates to reduce inflation

• Reduced Consumer Spending: 

Increasing interest rates make borrowing more expensive for consumers, including mortgages, auto loans, and credit cards. 

Higher borrowing costs can discourage consumer spending, particularly on big-ticket items, leading to a decline in consumption. This reduction in consumer spending can have a dampening effect on economic growth

• Decreased Business Investment

• Higher interest rates can also raise the cost of borrowing for businesses. 

This can discourage investment in new projects, expansions, and equipment purchases. 

And our gold nuggets……

Dave Johnston’s gold nugget: Through understanding the risks that sit in the economy, investors can be better placed to understand the market long term. The benefits of long term planning hinge around managing risk.

Mike Mortlock’s gold nugget: “You can see that there’s a very complex interplay between things”, and Mike believes that every property investor should familiarise themselves with the RBA meeting discussions. The implications discussed in the RBA meeting minutes do have a real effect on property investors. Knowledge is power when it comes to making long term property decisions.

Resources:

If you enjoyed this episode, you may also enjoy these:

Ep. 89 – Capital growth – what increases property value?

Ep. 119 – How supply and demand dictates market movements

Ep. 155 – Plotting Australian property market movements from 1970 to now

Ep. 158 – How interest rate cycles have impacted the property market since 1990

Ep. 217 – the inflation conundrum; unravelling it’s causes and consequences