inflation Archives

How Interest Rates and Inflation Go Hand In Hand

Inflation in Australia has hit a sky high 5.1%, the highest it has been since 2008. The price of fuel, electricity, and even lettuce has all gone up by more than 50% in the past year. To counter the rising inflation, the Reserve Bank of Australia (RBA) has raised the official cash rate in consecutive months, the first time this has happened since May 2010. The cash rate is now at 0.85%, up from 0.1% just over six weeks ago. And more interest rate rises are still to come. It’s all part of the RBA’s plan to keep Australia’s inflation between its target of 2 to 3 percent. But how does this work? How does increasing the cash rate reduce inflation? Increasing Interest Rates Reduce Demand The Reserve Bank of Australia is responsible for setting the cash rate, which is the interest rate that banks use for overnight loans to each other. The cash rate helps determine the interest rate at which money is lent or borrowed by consumers and businesses. So when the RBA increases the cash rate, it raises the cost of borrowing for banks. And naturally, the banks pass on the higher cost of borrowing to consumers and businesses. This means that when the RBA raised its cash rate by 0.5% last week, consumers and businesses will have to pay more to borrow money. *However, it’s important to note that a 0.5% increase in the cash rate doesn’t mean that the interest rate quoted by the banks will also increase by 0.5%. This higher cost of borrowing will reduce the demand of products and services and reduce the overall economic activity. For example, if your weekly mortgage repayments go up, you have less money (discretionary income) to spend on other goods. For businesses, a higher loan repayment might mean that the business will be less likely to invest in new equipment or hire additional workers. This reduced demand for goods and services is exactly what slows down the rate of inflation. Basic economics says that the prices of goods and services increase when there is greater demand (law of demand). But when it costs more to borrow money, the overall demand for goods and services decrease. Whilst prices might not necessarily decline, the rate of inflation usually does. Real Life Example To better understand how the two are linked, let’s consider a typical household with two loans: a home loan and a car loan. Inflation has been sky high during the pandemic, and thus the price of everything has gone up. If the interest rate on your loans goes up, then you would need to spend more of your disposable income on those repayments. As your repayments on the loans increase, the household has less discretionary income to spend in other areas, such as going to the cinema. From the cinema’s perspective, there’s a drop in demand as most movie-goers can no longer afford that luxury. The cinema’s revenue decreases. If you’re a cinema owner, you might decide to reduce the price of the ticket in order to entice some of the movie- goers back. But because you decided to drop the prices, your profit margins decrease. The tighter profit margin means that you can no longer afford to hire all the staff, so you decide to lay some people off. As a result, less people have jobs. Thus less people will have the money to go to the cinemas, further reducing the demand for your goods. Now imagine it’s not just one cinema, or one business, but the entire country’s economy. Even small increases in cash rates can have ripple effects that significantly slows down the country’s economic activity. Thus, companies would no longer be able to raise prices. Thus, by increasing the cash rate, the Reserve Bank of Australia has reduced the ability of companies to raise prices for goods and services, thereby slowing inflation.

Why Saving Money Is A Myth

Leave a Comment / Andy Lee / May 3, 2022

So you’ve just landed your first job and received your first paycheck. You suddenly have access to a lot more money than you have previously. So what do you do with your money? Well, you’ve got two options. Spend it, or save it. Most people, including you, will probably do a combination of both. You spend some of your paycheck now, for necessities and for pleasures. And like most people, you’ll probably save the rest for a rainy day. But now is where it gets interesting. I can say with 99% certainty that the first place you think of putting your hard earned money is in the bank. But is putting your ‘savings’ in a bank really the best idea? Here’s what I mean. You’re Losing Money Every Year Inflation is the general increase in the prices of goods and services. When prices increase, your dollars are able to purchase fewer goods and services. In other words, you can buy more stuff for $100 in 2000 compared to $100 today. To measure the inflation (or deflation, which is negative inflation) rate, the Consumer Price Index (CPI) is used. The CPI measures the weighted price change for a basket of common household purchases. This includes goods such as food, housing, and recreational activities. (You can see all the items included in the CPI and their weights here) What this all means is that you’re essentially losing money every year in the form of reduced purchasing power. Is ‘Saving’ Money A Big Lie? Here’s where it gets interesting. According to the Australian Bureau of Statistics (ABS), the average inflation rate for the past five years has been 1.98%. So unless your bank has been offering you interest rates greater than 1.98% per annum for your savings account, you’ve been losing money, not saving money. The Big Four However, that doesn’t seem to be the case. According to finder.com.au, over the last five years, the average interest rate for savings accounts among the Big Four Banks (Commbank, Nab, Westpac, and ANZ) was only 1.54%. Which means that although the money in your savings account has increased in absolute terms, you are only able to purchase fewer goods and services with the money in your savings account compared to five years ago. Pandemic-Induced? However, it’s also important to note the effects of the pandemic. Due to the pandemic, a lot of actions were taken in order to stimulate the economy. Firstly, the Reserve Bank of Australia reduced the cash rate to a historic low 0.1%. By reducing the cash rate, it also caused banks to reduce their interest rates. While low interest rates are good for borrowers (they pay less interest to the banks), they are bad for savers as the amount of interest paid by the banks to savers is reduced. By reducing the cash rate, it encourages people to spend their money now rather than later. Secondly, the pandemic also caused a lot of supply chain disruptions and shortages. Right now, there is a shortage on graphic cards and computer chips. As there is a computer chip in almost everything (smartphones, cars, and whitegoods to name a few), a chip shortage causes flow-on effect on the supply of other goods as well. Lastly, the large stimulus provided by the Australian government intended to stimulate the economy during the pandemic introduced a lot of ‘new money’ into the money supply. As the money supply increased, the availability of some goods and services also declined (remember the toilet paper hoarding of 2020 anyone?). This increased demand caused the prices of some goods and services to go up as well. So back to investigating whether savings account are a myth. If we note that the last two years were anomalies due to Covid and exclude their data, the inflation rate for the five year period before Covid (2015 to 2019) was 1.75%. The average interest rate for savings accounts among the Big Four during the same period was 2.32%. So if we exclude the wild events from the past two years, saving money is most likely not a myth. Other Sources to Consider But high interest savings accounts are not the only place where you can put your savings. There are other avenues available, like term deposits, bonds, stocks, and even crypto. But that’s a story for another time.

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