MONEY MATTERS

MONEY MATTERS MONDAY 12TH APRIL 2010
By Robert Frogley

What Drives Interest Rate Decisions

The Reserve Bank of Australia (RBA) hiked interest rates again last week and undoubtedly more rate rises will come this year and next.

The RBA is convinced the Australian economic recovery is well under way and it wants to make sure it manages the conditions in a way that will ensure the recovery is sustainable.

While it is now clear the recovery has begun people may be puzzled why the RBA needs to raise rates so early in the recovery cycle. Small business owners in particular are far from experiencing boom conditions, the usual cause of rate rises, and cannot see any need for rate hikes yet.

The RBA is raising rates because they were cut to forty-nine year lows during the global financial crisis. In order to minimize the number of businesses that failed due to the financial stress conditions rates were kept extremely low.

Borrowing was cheap and readily available to businesses and consumers to keep the economy moving. The first few rate rises have been simply to lift rates from the emergency low levels back towards their neutral position.

The RBA is also lifting rates early because it takes a long time for rate changes, up or down, to have an effect. The full effect of changes takes six to nine months to flow through.

It’s like piloting the Queen Mary 2. If you want the ship to turn in a little while you should have already turned the wheel. The RBA wants to keep the economic settings just right to ensure problems such as inflation are avoided.

The Reserve Bank is independent of the Government and makes its decisions without regard to the political effects. It is governed by a charter setting out its objectives and guidelines. The primary ones are to control inflation and to maintain employment as near to full as possible.

The level of interest rates affects both. Consider what would happen if the RBA left rates very low for a long time. Borrowing would be really cheap and economic growth would accelerate. People would borrow for consumer goods, for business and for investment.

There would be too much cash chasing too few goods and prices would increase, inflation would rise. It is very difficult to live with for many reasons. Those who recall the 12 and 15 per cent inflation of the 1970’s and 1980’s remember prices rising every week.

Prolonged low interest rates would also cause economic boom conditions, which usually lead to a nasty bust. Extra strong growth is unsustainable. Things get out of balance, speculation becomes rampant and a collapse occurs.

Conversely if the RBA kept interest rates too high for too long it would strangle activity and cause unemployment. High interest rates mean people and businesses cannot afford or choose not to borrow. So consumer spending falls and business turnover and profits fall.

Companies then look for ways to cut costs and start retrenching staff. Unemployment rises. Consumer spending then falls further because fewer people have jobs and incomes, and the situation gets worse.

The RBA aims to keep rates at a level that will encourage spending and business activity but not too much. It wants growth at a reasonable rate providing many jobs and near full employment, but it doesn’t want overly strong growth causing inflation to rise and boom conditions to develop.

We are a long way from boom conditions at present and business owners especially are saying the rate hikes will kill off the recovery. However the RBA is worried about the speculation in house prices in the capital cities.

The extreme low rates have enabled investors to borrow more to buy up city residential properties, pushing prices further above their already high levels. There is almost a bubble situation in some areas and the RBA wants to stop it developing further.