why are high inflation and interest rate rises directly related?

[beachgurl]

This is probably a stupid question, but I can't work out why high inflation means that interest rates need to go up. Only 30% of the population are paying off their home, so how does a detrimental effect to 30% of the market bring down spending overall? I would think that it is generally those renting who spend all of their disposable income, not those with big home loan debts.

I understand that rents would go up eventually, but with a few rate rises in a small time frame, most PMs would not allow you to increase rents to the same degree. So tenants would be unlikely to suddently cut spending when hit with a $10 per week rent rise that takes effect in 3 months time.

To all those economists/accountants out there, can you explain this to me or send me a link of an explanation of this? thanks in advance

 

[alexlee]

A simple explanation is this: inflation is too much money chasing too few goods. So one way to reduce inflation is to reduce demand. If you make the price of money (interest rates) higher, then people (including businesses) are less likely to borrow as much. So the demand for goods decreases, and inflation (theoretically) falls.

There are other ways of doing this, such as cutting government spending. But the RBA only has one weapon: interest rates.
Alex

 

[beachgurl]

Thanks Alex,

I understand the concept of why the interest rates are raised, but it just doesn't make sense when the resulting interest rate rises affect less than 50% of the population. Is it simply that there is no other method to reduce spending and it is hoped that interest rate rises freak out the rest of the population to reduce their spending?

 

[Bill.L]

Hi all,

Alex while that is the theory, I have a feeling that some part of the theory is not accurate.

Part of my theory is that by raising rates a little by little over the last few years is akin to boiling the frog slowly. All the interest rate rises have done so far is to raise inflation. Most people (business included) have been thinking that it is only another 1/4 percent and shrugged it off as higher costs.

If instead of the last four 1/4 percent rises, we had just had a sudden 1 percent increase, the effect would have been immediate and reined in money supply growth.

Just like the frog, if you throw it into hot water, it will immediately jump out. However by heating it slowly, you can cook it.
If we replaced the frog with a goose (am I talking politics here?) hopefully ours is not cooked.

Because economics is art and not science, after every major boom/downturn the theories of what to do (and what should have been done) get tweeked with the latest theory (and tried).

bye

 

[Trogdor]

This is probably a stupid question, but I can't work out why high inflation means that interest rates need to go up. Only 30% of the population are paying off their home, so how does a detrimental effect to 30% of the market bring down spending overall? I would think that it is generally those renting who spend all of their disposable income, not those with big home loan debts.

I understand that rents would go up eventually, but with a few rate rises in a small time frame, most PMs would not allow you to increase rents to the same degree. So tenants would be unlikely to suddently cut spending when hit with a $10 per week rent rise that takes effect in 3 months time.

To all those economists/accountants out there, can you explain this to me or send me a link of an explanation of this? thanks in advance

The residential sector and people's spending as individuals are only one part of the equation. Think of expansions big companies (mining companies building new mines, airlines ordering new planes, manufacturing companies building new factories, etc..) - these will be more or less willing to commit to such spending based on interest rates. Less spending on such items means less demand for workers, goods, land, etc... Hence less inflationary pressures.

Have a look at balance sheets of big listed co's and you can see interest expenses based on their borrowings (which, if these companies are unhedged will change with rates) and also reduce profits, hence dividends, etc....

 

[Trogdor]

Thanks Alex,

I understand the concept of why the interest rates are raised, but it just doesn't make sense when the resulting interest rate rises affect less than 50% of the population. Is it simply that there is no other method to reduce spending and it is hoped that interest rate rises freak out the rest of the population to reduce their spending?

A rise in rates will indirectly affect everybody (except for maybe hippies living in plots or communes in the middle of nowhere!)

 

[grossreal]

hi alex
it is also demand for goods.
so as the demand for goods increases (price is governed by supply and demand), so does the price ( or thats the theory) and as price increases this requires more cash and hence you have inflation.
interest rate doesn't have alot to do inflation, what it does is reduces ( or so they say) the amount of money (disposable income) you have to spend
this then reduces your demand for goods( because you don't have the money)
by reducing demand
you reduce the cash flow in the economy.
thats the theory anyway
the trouble is that with the invention of credit
then as you reduce the cash flow you increase the want or need for credit hence the use of cards or other forms of credit.
now as alex says the rba only has interest rates to play with ( thats not exactly true but will run with it for this post) increasing rates also increase credit cost and as credit cost more in interest
the people (again in theory) that want the car, boat, v8 etc will be either detered from buying or die off with forclosue.
the trouble is that there is two types of debt
the one above but also on the other side of the coin is that the goverment encourages you to go into debt and the more the merrier via negative gearing for property and credits on profit for companies.
and by increasing interest rates it helps a negative geared person as it reduces there tax income ( and if defering income to a date in the future you are for all intence and purpose waiting for a more profitable time)and again supply and demand comes in.
the supply has not increased but demand has.
this then pushes up price not on the boat and v8 guys items but on stocks and shares and real estate as investors capitalise on falling prices or what is seen as a bargin in both markets( and hey if the buy is a loss you can hit it to your tax).
so the rba has a very big problem
they have debt in the left hand with the v8 car guys( majority) and the flexible plastic and in the right the investors and companies (minority but with the majority of the governments ear)claiming losses and costs.
With the government pushing the right hand to go forth and prosper (getting part of there funding from these groups directly or indirectly)
and trying to hold up the left hand with its all fine and no problem and pointing the finger at anyone in the room but them( I am waiting for them to blame the news papers for this problem as john cleese would say it your problem you reported it).
and the poor old rba trying to control this whole thing.
wouldn't have there job in month of sundays they are not a shag on a rock, they are a shag on a rock with a crowd of people walking around with guns.
and they are all point them at the rba
one interest point and its not been point out anywhere that I have seen as yet before the election as mr rudd and mr swan said it was mr howards fault or problem but it was warned about 20 times before.
question
why did mr howard not fix the problem.
and if it was warned 20 time before the election then how come mr rudd said that under his group there would be no interest rate changes did he not read the 20 time or was he asleep.
the answer is simple
the rba, mr rudd and mr howard have no idea how to fix it.
so mr howard passes to mr rudd who passes to rba and the rba hasn't got anywhere to pass
so raise rates you lose as price rise less cash but more debt from investors and companies.
drop rates and prices rise as more cash available.

and just one little thing with regards to both the above and alex post.
I have been thru 17% rates and down to 4.5% rates and have been here and the uk and the theory not right.
I have not seen any real drop in prices when interest rates fall
what happens is rates rise demand is cooled on the plastic prices rise and when rates drop the price stays where it is, and then start to go up again as costs increase.

 

[Nuzdeano]

Thanks Alex,

I understand the concept of why the interest rates are raised, but it just doesn't make sense when the resulting interest rate rises affect less than 50% of the population. Is it simply that there is no other method to reduce spending and it is hoped that interest rate rises freak out the rest of the population to reduce their spending?

Hey beachgurl,
With less than half the population paying off a PPOR, it leaves more than half who own PPOR's along with people paying below market rent to continue spending unaffected by increasing interest bills each month.

One of the main reasons why we have had so many successive interest rate rises is because those unaffected by interest rate increases are spending more than enough to make up for the lack of spending by those paying off a PPOR.

The economy will get to a point where spending is reduced at a macro level that curbs inflation at which time the RBA stops increasing interest rates but who knows when that will be.

Dean

 

[alexlee]

Remember the official interest rates don't just affect mortgages. It affects credit cards, business loans, corporate bonds, etc. So it now costs businesses more to borrow, so they might no go ahead with certain projects, decreasing economic activity.
Alex

 

[Bushy]

My take on it is a little different
If interest rates rise the $au rises in value which makes imported goods cheaper.

If imported goods are cheaper and you don't have a home loan and you can buy something interest free for 36months- wouldn't you. I believe raising interest rates drives inflation not reduces it.Especially when we are consuming more imported goods than locally made.The cost of petrol which is one of the common consumerables is even cheaper when our dollar is high - regardless what a barrel of oil costs.($US)
The only way to slow inflation is to try to lower the aussie dollar, which equates to higher petrol costs and less demand for imported goods.
I have heard to only way to hedge against inflation is to buy property, property increases more than cpi.

If inflation is high the actual cost of money is cheaper. ie cpi 3%, int rates 7%the actual cost is 4%. cpi 1%, int rates 6% , actual cost 5%. Between 1973 and 1979 cpi peaked over 15% and int rates were around 10% meaning you should have borrowed as much as possible and bought appreciating assets as you made 5% just by borrowing.

If interest rates are low (low inflation) - homebuyers buy houses.
If interest rates are high (high inflation) - investors buy houses.

But then again I might be totally left field.
Regards Bushy

 

[luce.rocks]

If inflation is high the actual cost of money is cheaper. ie cpi 3%, int rates 7%the actual cost is 4%. cpi 1%, int rates 6% , actual cost 5%. Between 1973 and 1979 cpi peaked over 15% and int rates were around 10% meaning you should have borrowed as much as possible and bought appreciating assets as you made 5% just by borrowing.

If interest rates are low (low inflation) - homebuyers buy houses.
If interest rates are high (high inflation) - investors buy houses.

But then again I might be totally left field.
Regards Bushy

I'd never thought about it like that! What do you think are the chances we're going to see CPI up that high though?

 

[pudestcon]

Show me the money

Or more importantly, show me where the extra interest payments go. Is it into the banks bottom line profit? Is it into government coffers or does it just sit in one of those 'black holes'?

Pud

 

[stumunro]

God forbid you would actually want the economy to grow,

what is SOO bad about inflation anyway?

 

[alexlee]

God forbid you would actually want the economy to grow,

what is SOO bad about inflation anyway?

Because inflation just means more money chasing the same amount of goods. It doesn't actually mean our economy is growing in real terms. As a society, we don't want nominal growth that's just powered by more money flooding the system. We want 'real' growth (better goods, more efficient production, more production capacity, etc) as opposed to rising prices for the same goods.

As investors, since we use borrowed money, of course, just nominal growth helps us.
Alex

 

[Gremlin]

At the risk of sounding like a 'back in my day' type response...

I find the fascination with raising interest rates and 'mortgage stress' somewhat one sided. Interest rate increases are designed to have two impacts on the market. One, is to reduce the spending of those with large debt to service. Second, is to encourage greater levels of saving through higher risk free returns.

Both impacts are designed to reduce consumption (and hence inflation). Whether you're a net borrower or a net saver depends which end of the same blunt stick the RBA is trying to poke you with.

25-30 years ago that was understood. Now, probably because as a nation we have a debt obsession, the focus is entirely on the 'mortgage stress' side of the coin. And that's why we keep hearing this flawed argument that the RBA is trying to dampen spending by penalising only 30%.

 

[yieldmatters]

As a society, we don't want nominal growth that's just powered by more money flooding the system. We want 'real' growth (better goods, more efficient production, more production capacity, etc) as opposed to rising prices for the same goods.
Alex

Oh my goodness!!!!!!!!

Does this apply to housing?!!??

 

[alexlee]

Oh my goodness!!!!!!!!

Does this apply to housing?!!??

What's good for me being sometimes different from what is good for society, of course. The money that goes into housing can be much better spent on education, research, etc. If that happens, great. Since it doesn't.... I'll just profit from it.
Alex

 

[Bushy]

Another way to think about it is.

Inflation is good if you rely on your assets growing more than your income.

Inflation lowers your income because you can't buy as much with the same amount of money as last year.( bad news if you are in the rat race)

Inflation lowers your debt on appreciating assets because if your asset has gone up in value and your debt stayed the same in dollar value, you now own a greater percentage of your asset. That is why I think Interest /Only loans are the way to go - Inflation will lower your debt faster than Principle / Interest

Your feedback welcome.
Regards Bushy

 

[sailor]

Both impacts are designed to reduce consumption (and hence inflation). Whether you're a net borrower or a net saver depends which end of the same blunt stick the RBA is trying to poke you with.

So why doesn't the RBA just raise the interest rates on cr cards? Surely this would curb spending?

 

[alexlee]

So why doesn't the RBA just raise the interest rates on cr cards? Surely this would curb spending?

Because the RBA can't target interest rates that specifically. They only have one rate they control: most variable rate loans are priced off that. They can't say let's raise credit card rates and cut mortgage rates. You don't want them to have that power anyway.
Alex