November 2023 Newsletter
Why did the Reserve Bank increase interest rates on Melbourne Cup day when inflation is dropping everywhere else?
A short newsletter discussing interest rates as it is something that affects us all.
Someone asked me: Why did the Reserve Bank increase interest rates on
Melbourne Cup day when inflation is dropping everywhere else?
To some extent the question answers itself in that we now have the highest inflation rate among the 15 largest industrialised nations, but there is more to it…
Why is our inflation rate so high?
The official answer is because we have a large number of migrants – some 500,000 a year or 2% of the population, with most of those migrants being skilled workers and their families. Such people on the whole earn a good income and are new to the country and therefore usually spend money to establish themselves.
Consequences are higher house prices in places where migrants go, especially Sydney and Melbourne, higher rents in most places, and higher demand for goods and services.
If you add in a general drop in worker productivity as we have observed in recent times plus a shortage of skilled labour – despite the large scale migration – then you have the recipe for a lot of home-grown inflation. If you further add large increases in electricity prices because more and more power stations are turned off, everything that depends on electricity also gets more expensive.
In addition, we have a Reserve Bank that recently got its forecast badly wrong – rates were supposedly remaining at zero for a further 3 years while instead they moved to 4.35% and the Reserve Bank is therefore fighting for its credibility. For a central banker ‘credibility’ means aggressive rate rises in order to snuff out inflation.
What is the theory behind rate rises reducing inflation?
The higher rates are, the more interest people need to pay for their mortgages and other loans and the fewer investments and projects are undertaken by businesses as the financing of investments and projects becomes more expensive and difficult. With less demand, producers and service providers are forced to cut their prices and inflation is supposedly subdued.
That doesn’t quite work though when there is lots of new demand from migration and less supply due to drops in productivity.
The current situation is not as beneficial as it may appear for investors either. High interest rates are normally a boon for investors and pensioners as they get to see a return on their cash and term deposits, but those higher returns are illusory if they are eaten up by inflation and taxes. In other words, because inflation is higher than interest rates and many pay tax on the interest paid, many savers and investors are actually worse off than during the time when inflation was low and term deposits paid 0.25%.
Personally I think skilled migration is a very good thing as such people make the country richer and give more opportunities for everyone, but at the moment we are in the painful part of the process (as shown on the two graphs below) and the knee jerk reactions of the reserve bank may not be supporting it.
There is also another source of higher interest rates: Supply and demand. Especially the US and the Australian government are borrowing much larger amounts than they did in the past. In the US, federal government debt is currently growing at unheard-of rates. At the same time one of the biggest buyers of US government debts, China, is actively reducing their exposure, i.e. selling American debt. As a result, long-term interest rates, rates which are not controlled by the US Federal Reserve Bank or the Reserve Bank of Australia (RBA) have very substantially increased and this increase has a strong influence on items such as mortgage rates and the interest rates at which businesses can borrow.
When long-term rates, i.e. when governments borrow for 10, 20, or 30 years, go up a lot, then the RBA needs to take notice and that could well be another reason for the RBA to raise rates when from many perspectives it looked like too hasty an increase, same as they did in 2007 and where the RBA then – after the damage was done – had to lower rates in a hurry in 2008. It is not easy being a central bank or RBA bank governor when the government spends too much on unproductive schemes and there may be an element of that here as well.
What to do as an investor or borrower?
That really depends on how much longer the government will borrow large amounts of money and subsidise investments that don’t increase our wealth. The moment they reduce this or stop, interest rates can fall. If they increase these activities, rates will be higher for longer.
There is an enormous amount of change happening in the world at the moment but there are no imminent signs of any major collapse and even when the future looked bleak as it did in March 2020, so far we recovered quickly. There are no guarantees for the future but there are also a lot of opportunities and Australia can bounce back quickly from the current situation.
Please feel free to contact us at any time with any questions or support you may require. We always look forward to hearing from you.
With love from the Team at In Your Interest Financial Planning
Christoph, Nicola, Marian, Deryk,
Ann-Marie, Jessica, Alvin, Lin and Yvonne
Dr Christoph Schnelle
Life Risk Insurance Specialist
SMSF Specialist Adviser
TEP Trust and Estate Practitioner
PhD Health Sciences and Medicine
GStat Graduate Statistician
Accredited Estate Planning Professional
Accredited Aged Care Professional
Authorised Representative 308223
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