Has The Christmas Grinch Come Early? My Take On Rates, RBA And Basic Economics.

Crisis over or diverted or put off or whatever, but the Australian Reserve Bank has raised the cash rate – the first Reserve Bank in the world since the big ‘GFC’.

Well what the heck does this actually mean and why have they done it?

I’m no economist. I can’t read complicated equations and fiscal models. I need things dummied down to my level to understand them. This is my dummy’s economics understanding in a nutshell and the ‘x-factor’ that I think we forget about when talking economics.

The Reserve Bank is like the defender of Australian economic stability. Their aim is to contribute to the growth of the economy and to promote full employment. To fulfil their role, they must fight to keep inflation low. Their main weapon against inflation: interest rates.

The RBA doesn’t actually tell banks what interest rates to set (as we saw with renegade banks not lowering their interest rates on mortgages during the "GFC”). Instead they indirectly control the interest rate or cash rate on the short term money market.

So, you deposit your hard earned cash into your local bank, and the bank then goes and lends it for a profit (at the RBA’s cash rate) to other institutions on the short term money market. A tiny portion of this profit is passed onto you as interest on your savings. The higher the cash rate, the more interest the bank gets, the more interest you get.

On the other hand, the bank also borrows money (at the cash rate). The cost of short term money market borrowing is passed on to you as interest rates on debt, plus some extra interest added on so that the banks can “cover their costs” and profit on your borrowings as well as your savings. (I won’t even start with fees)! To ensure that the banks earn profits, there is an uneven distribution between the interest we get on our savings accounts and the interest we pay on our debts and increased interest on debt is passed on much quicker than increased interest on savings.

When cash rates go up, the interest rate on mortgages, car loans, personal loans and credit card go up along with our repayments and we have less $$ in the family budget to spend on other stuff.

So how does this control economic stability? And how does it affect inflation?

Inflation is when the general level of prices across a range of goods rise. The higher the inflation, the less your dollar can buy and the harder things get for low income earners.

When no one is spending any money, or there is an oversupply of certain goods or plenty of competition, demand is low and prices remain constant or some go down in order to entice you to spend. Inflation stays low.

On the other hand, when the economy is booming, there is money (or credit) to throw around, demand is high and prices of goods increase and this is reflected by the increased inflation rate.

The RBA influences this balance between supply and demand by adjusting the cash rate and making it easier or harder for us to spend on necessary and discretionary goods. When it’s easier, prices and inflation go up, when it’s harder to spend, prices and inflation remain low.

Obviously, this is way oversimplified, but it’s as good as I understand it. However, this rudimentary explanation is complicated by several factors.

First is the government’s fiscal policy. For better or for worse, our Kevin is stimulating the BG’s out of us all nicely, which is giving us more money to spend, hence is raising inflation at a rate that the RBA is not comfortable with. So interest rates go up. Government spending in another way of influencing the economic cycle.

Second is that it doesn’t really take into account other factors that affect inflation on necessary goods. Like drought. Or cyclones. Or cost of transporting food. It doesn’t matter if the RBA raise the rates to billy-o, we still need to eat. It just makes it harder for lower income families, but then, so does inflation. Double whammy.

And finally the system kind of assumes a closed economy rather than a global one. Inflation is affected by factors outside of Australia. For example, the RBA’s influence over the cash rate will have no influence over the increasing global demand for oil, and the increasing global cost of oil, which leads to localised inflation. Triple whammy.

So what does all this mean?

Less ‘spending’ money for you and I. Oh, and just before Christmas, the retail industry reminds us.

We can talk about growth rates and Gross Domestic Product and retail statistics and unemployment rates, but there is one important factor that I don’t think gets talked about in all of this.

Our whole economic system is based mainly on consumption.

Economic ‘stability’ is leveraged on manipulating our ability to consume or not. And consume we do.

What is the ‘x-factor’ in increasing the interest rates that doesn’t get mentioned?

Those of us who have been frugal for a while have thrown around the question: will the new frugal ‘trend’ last? Or will we go back to our consuming ways? Well the rise in interest rates suggest that we already might have.

I think there is more at stake here than economic recovery. It’s much more complex than buy and sell. Lend and be lent to. Maybe it’s time to reassess our economic model and add in the ‘x-factor’: how are we going to deal with finite resources (apart from the usual and inadequate opportunity cost argument) and the generation of waste and pollution that is inherent in an economic model based on consumption?

Have you read these posts?

1. Choosing a Mortgage that’s Right for You
2. a man drove into town – a story of modern economics
3. start a christmas fund and take the sting out of christmas cheer
4. Tutorial: Building A Basic Budget In Excel (For The Absolute Excel Beginners) Part 1
5. food for thought thursday–the price of goods