actually - is someone able to give a quick bullet point overview of what the real underlying issues/root causes are that the Govt are trying to solve. Like it seems we're increasing interest rates to decrease spending in the hope this will decrease inflation (not actually sure how this works)...but what is the real underlying issue we're trying to solve? Is it just home affordability?
How high will interest rates go?
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To give you some context, one of the first things that students of economics learn are what generally accepted to be the four main aims of economic policy, which in no particular order are:
- Price stability (a low stable CPI)
- Economic Growth (Real GDP per capita)
- External Balance (a low CAD)
- Full employment (with allowance for "normal" levels of structural / cyclical / frictional unemployment
If you're interested, a post of mine from 2004 explains those 4 aims in some detail and the challenges the government faces in trying to achieve them (they conflict with each other).
Home affordability isn't generally regarded as a main aim of economic policy, though it has become very popular (and contentious) in recent years.
Returning to the issue at hand, the government, via the RBA, uses monetary policy to assist with the wider goal of price stability.
In the RBA's own words:
Movements in the cash rate are passed through quite quickly to the whole structure of deposit and lending rates, however changes in these interest rates affect economic activity and inflation with much longer lags. This is because it takes time for individuals and businesses to adjust their behaviour. There are several distinct channels through which changes in interest rates ultimately affect prices (and hence inflation) in the economy.
Interest rates affect economic activity via a number of mechanisms. They can affect savings and investment behaviour, the spending behaviour of households, the supply of credit, asset prices and the exchange rate, all of which affect the level of aggregate demand. Developments in aggregate demand, in conjunction with developments in aggregate supply, in turn have an effect on the level of inflation in the economy. Inflation is also influenced by the effect that changes in interest rates have on imported goods prices, via the exchange rate, and through their effect on inflation expectations more generally in the economy.
M
- Price stability (a low stable CPI)
- Economic Growth (Real GDP per capita)
- External Balance (a low CAD)
- Full employment (with allowance for "normal" levels of structural / cyclical / frictional unemployment
If you're interested, a post of mine from 2004 explains those 4 aims in some detail and the challenges the government faces in trying to achieve them (they conflict with each other).
Home affordability isn't generally regarded as a main aim of economic policy, though it has become very popular (and contentious) in recent years.
Returning to the issue at hand, the government, via the RBA, uses monetary policy to assist with the wider goal of price stability.
In the RBA's own words:
Movements in the cash rate are passed through quite quickly to the whole structure of deposit and lending rates, however changes in these interest rates affect economic activity and inflation with much longer lags. This is because it takes time for individuals and businesses to adjust their behaviour. There are several distinct channels through which changes in interest rates ultimately affect prices (and hence inflation) in the economy.
Interest rates affect economic activity via a number of mechanisms. They can affect savings and investment behaviour, the spending behaviour of households, the supply of credit, asset prices and the exchange rate, all of which affect the level of aggregate demand. Developments in aggregate demand, in conjunction with developments in aggregate supply, in turn have an effect on the level of inflation in the economy. Inflation is also influenced by the effect that changes in interest rates have on imported goods prices, via the exchange rate, and through their effect on inflation expectations more generally in the economy.
M
Again, in the words of the RBA:
The Reserve Bank of Australia (RBA) is responsible for formulating and implementing monetary policy. The Board's obligations with respect to monetary policy are laid out in the Reserve Bank Act 1959. Section 10(2) of the Act, which is often referred to as the Bank's 'charter', says:
"It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank ... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:
(a) the stability of the currency of Australia;
(b) the maintenance of full employment in Australia; and
(c) the economic prosperity and welfare of the people of Australia."
Since 1993, these objectives have found practical expression in a target for consumer price inflation, of 2-3 per cent per annum. Monetary policy aims to achieve this over the medium term and, subject to that, to encourage strong and sustainable growth in the economy. Controlling inflation preserves the value of money. In the long run, this is the principal way in which monetary policy can help to form a sound basis for long-term growth in the economy.
In truth it is a bit of both, in that a low, stable CPI is an end goal but, more importantly, seen as contributing to the larger aim of having an economy that supports and fosters sustainable growth (refer to my post above re: aims of policy).
In that particular case it simply would mean that real wages would have been maintained.
High inflation (and different people may have different definitions of what that is) is undesirable.
High inflation brings with it numerous costs. Notwithstanding the erosion of the purchasing power of each dollar which I am sure everyone here is familiar with (this is the main cost of inflation where real incomes are not maintained), other costs include:
a) Adjustment costs - price lists and prices have to be continually adjusted to keep current with CPI
b) Search costs - the higher the CPI, the greater effort that consumers will put into making informed choices in an attempt to find the cheapest prices.
A certain level of inflation is desirable (again, open to some debate) as it represents an economy experiencing growth spurts (pressures to get larger) and in this respect it is healthy. Beyond a certain point (high single digit % pa or above I would suggest) inflation represents an economy out of control and this undesirable.
Developing nations often experience higher levels of inflation (because, among other things, they typically experience higher levels of economic growth), but in mature 1st world economies the inflation appetite is much lower.
M
MU, while interest rates obviously have a big effect on property investing because it's a major cost, don't get too deep into trying to time the market based on interest rates.
Many property investors do perfectly well even though they don't understand a thing about interest rates.
Read up about it and try to understand it, by all means, but don't start thinking 'I'll learn everything about the market so that I can buy at the right time'. You'll just bury yourself in articles and books and never end up buying anything. Because no one knows it all, and quite frankly no one can predict the market.
Alex
Many property investors do perfectly well even though they don't understand a thing about interest rates.
Read up about it and try to understand it, by all means, but don't start thinking 'I'll learn everything about the market so that I can buy at the right time'. You'll just bury yourself in articles and books and never end up buying anything. Because no one knows it all, and quite frankly no one can predict the market.
Alex
The earnings may be higher, however the spending power of the savings is being eroded quicker in a high-inflkationary environment, and throw in tax rates and to just break-even in real terms is doing fairly well.
You are correct, I doubt anyone who is without a mortgage would really be happy in a high-interest rate environment as property prices will suffer due to the flow-on effects of tightening credit. This effects the propects of sale, the equity available for use and most people would have some first-hand knowledge of a friend/neighbour who is already having to tighten their belts to meet higher interest repayments. Already securitised lenders are pullling out of the Australian market & we face the serious prospect of prolonged stagflation in teh US will will hinder any recovery in the short term.
Hi Mark,
I understand your argument was that the inflation target should be increased to 5%, to limit unemployment. My point is that once you allow inflation expectations to build in, you can't get it back down again, without a recession.
Say you let it go to 5%. Now 5% is the expected level and is the new neutral setting for the economy. Another inflationary episode occurs. If you hold inflation to 5%, unemployment will rise. Do you let it go to 8%?. Back to square one, except people holding cash are now 8% worse off a year instead of 3% for no benefit.
See the quarterly figures below. Inflation was so entrenched around 7% (you're right, it's not 6%), rates had to go to 18% and trigger a recession before it would go down. No-one wants a repeat of that scenario.
Qtr - Inflation
Mar 88 6.9% (rates around 11%)
Jun 88 7.1%
Sep 88 7.4%
Dec 88 7.6% (rates at 15%)
Mar 89 6.9%
Jun 89 7.6%
Sep 89 8%
Dec 89 7.8% (rates 18%)
Mar 90 8.6%
Jun 90 7.7%
Sep 90 6.1%
Dec 90 6.9% (recession begins)
Mar 91 4.1%
Jun 91 3.4%
Sep 91 3.2%
Dec 91 1.5% (rates at 8%)
plot of property growth/inflation/interest rates???
does anyone have a graph of the following plotted over the last 40 years or so that they could post?
- property growth
- inflation
- interest rate
As a bonus if it had the following that would be nice
- unemployment
- share market growth
does anyone have a graph of the following plotted over the last 40 years or so that they could post?
- property growth
- inflation
- interest rate
As a bonus if it had the following that would be nice
- unemployment
- share market growth
MU, seriously, don't get TOO wrapped up in the statistics. What do you expect to learn from such a graph? Academically interesting, yes, but you run the risk of tying yourself up in knots about when to buy. Over the long term, (say 10+ years) when would have been a good year to buy property? Most of them, I would imagine. Some years are better, of course, but most of the time you can't tell until after the fact. That's why most people complain 'I should have bought then'. Why didn't they? Because it doesn't always look that good when you're in the middle of it.
Alex
Alex
I actually find it interesting AlexAlways good to learn.
I find it interesting too. But I don't let it stop me from buying property even if the timing doesn't look perfect. Sometimes, learning too much theory is counterproductive. Professors don't always make good investors.
Alex
Hi MU,
Yes, I did something similar a while back. Unfortunately cant find it. It took a while to get set of data etc... i think you should do it, before making any historic assumptions etc. Its quite a revelation...
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