An oft-used monetary policy analogy describes the nation as a farm. The central bank is in charge of water and irrigation on this farm.
The RBAs job is to keep the water (money) flowing enough to maximise crops (strong job creation). But, not pump in so much water as to cause flooding (inflation).
The RBA is responsible for achieving price stability (low and stable inflation). Here is a short overview of how the RBA achieves stable inflation and job growth, and how it can go wrong.
Is the tap on or off
Economic policy is divided into two channels, fiscal and monetary. Both have the power to significantly shape the economy.
Fiscal policy is performed by governments and takes the form of changes to tax rates, or changes to transfer payments, such as jobseeker.
The RBA, Australia’s central bank, is responsible for monetary policy. This takes the form of changes to the cash and interest rates.
Monetary policy exists in two forms, contractionary and expansionary.
Contractionary policy turns the tap off. The RBA uses this policy to slow the economy, combating rising inflation or other economic distortions.
Contractionary policy is performed by raising the overnight cash rate. The cash rate is the interest rate banks charge each other overnight to meet their reserve requirements.
Expansionary policy turns the tap on. It is used to stimulate the economy. The primary aim of expansionary policy is to boost total economic demand, making up for shortfalls in private demand.
The RBA lowers the overnight cash rate to perform this, making money more affordable.
The bank will engage in either policy depending on the nation’s economic conditions.
But how does the cash rate determine spending?
The ripple of the cash rate through the economy can be described as follows. In this case, we’ll focus on what happens when monetary policy is contracted or “tightened”.
- The Reserve Bank raises the overnight cash rate.
- Financial markets and banks update expectations about the future path of cash rates. The structure of deposit and lending rates are quickly altered.
- Over time, households and businesses respond to higher interest rates. They decrease their demand for credit, goods, services, and assets (such as housing and equities).
- All else being equal, falling demand decreases the prices of goods and services. The price-setting behaviour of firms depends on demand and the cost of inputs, including labour.
- Pressure is taken off the labour market. Wage and job growth slows on account of decreased demand for labour, keeping wages low and unemployment high.
For expansionary policy, the same process applies in opposite. The cash rate is lowered, interest rates drop. Households and businesses respond to the new rates, driving demand and prices up.
Two years of cheap cash
In 2020, the pandemic hit, and economic flows dried up. In response to this, the RBA dropped the cash rate to a record low of 0.1 per cent. The expansionary policy helped maintain healthy economic conditions during the pandemic.
This resulted in two years of very cheap loans with low Loan to Value Ratios (LVR).
The LVR is the amount borrowed, represented as a percentage of the value of the asset being bought. The bigger the deposit, the lower the LVR will be.
Inexpensive loans have encouraged business owners to invest and spend within the economy. Low interest rates have also driven competition, increasing the value of the businesses themselves.
Working in tandem, these two factors have helped prop up Australia’s economy, and have led to increased asset prices. Yet, the extra money spent by businesses has contributed to inflationary pressure.
We are now seeing the effects of an overstimulated economy. Expansionary policy is a good tool for managing low-growth, but it comes with risks.
Expanding too much can cause side effects such as high inflation or an overheated economy, which we are currently seeing.
Once the RBA makes the decision the economy is overheated and signals they will raise interest rates there is a risk business and asset value will drop sharply. Hurting the economy, jobs and business owners.
So how likely is this to happen? It’s almost certain.
What happens if the cash rate goes up?
The RBA is playing a delicate balancing game between the potential risks of a rate rise, and the damage inflation will cause.
The pandemic has caused significant inflation around the world.
Inflation in the US has recently reached a 39 year high of 6.8 per cent. Up from 2.3 per cent at the end of 2019 and three times the ten-year average.
Australian inflation has risen, but by a smaller size. Up from 1.8 per cent to 3.5 per cent currently and less than double the ten-year average.
Yet, businesses in Australia should steady themselves against potential higher inflation.
The RBA is signalling that the record low cash rate may soon be increased. The move would combat runaway inflation.
This will have flow-on effects for Australia’s economy. Westpac expects the Reserve Bank to start raising official interest rates as early as August 2022.
The bank is also predicting that the cash rate will reach a maximum of 1.75 per cent by August 2024. A 1.65 per cent increase on the current RBA cash rate target of 0.1 per cent.
Reserve Bank figures show that the average existing variable borrower is on a rate below 3 per cent. The expected rate rise would take a typical mortgage above 4.6 per cent.
RateCity analysis shows that this increase would cost someone with a typical $500,000 mortgage an extra $427 a month by March 2024.
“While the exact timing of the next cash rate hike is still uncertain, borrowers need to know that rates are on the rise — it’s a matter of when,” said RateCity’s research director Sally Tindall.
“Recent APRA data shows the average borrower is currently 45 months ahead on their repayments. However, that doesn’t mean every borrower will be able to take these rate hikes in their stride.
“One way you can prepare for future hikes is to get ahead on your repayments now while rates are still low. The lower your loan size when rates do rise, the less pain you’ll feel.”
Deciding when to engage in monetary policy, how much to do, and when to stop requires sophisticated analysis. The process involves substantial uncertainties and can have unexpected effects.
Minutes from the RBAs last policy meeting show the bank has no intention of lifting rates until it sees wages grow.
“This will require the labour market to be tight enough to generate wages growth that is materially higher than it is currently. This is likely to take some time and the board is prepared to be patient.”
So for now it would appear the tap will remain on.