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A Deep Dive on Inflation and Interest Rates

Inflation has risen significantly in Australia over the past 12 months, causing the Reserve Bank of Australia to hike the cash rate in response.

But this increase in inflation and official interest rates is actually a global phenomenon.

In America, inflation increased from 5.3% in August 2021 to 8.3% in August 2022, according to the most recent data from the US Bureau of Labor Statistics.

As a result, America’s central bank, the Federal Reserve, increased its benchmark interest rate from a range of 0.00-0.25% in March to 3.00-3.25% in September. More hikes are all but certain, with the Federal Reserve saying it “anticipates that ongoing increases” will be “appropriate”.

A similar story has been playing out in the UK:

  • Inflation has jumped from 3.0% to 8.6% (Aug 2021 to Aug 2022)
  • The benchmark interest rate has risen from 0.25% to 2.25% (Dec 2021 to Sep 2022)

And New Zealand as well:

  • Inflation has climbed from 3.3% to 7.3% (Jun 2021 to Jun 2022)
  • Official interest rates have increased from 0.50% to 3.00% (Oct 2021 to Aug 2022)

What about Australia?

The Reserve Bank of Australia (RBA) aims to keep inflation to a target range of 2-3%.

Inflation escaped that range in August 2021, when it jumped from 2.5% to 3.2%. Inflation has since trended upwards, reaching 6.8% in August 2022, according to the most recent data from the Australian Bureau of Statistics (ABS).

 

The RBA has responded by tightening monetary policy, increasing the cash rate at every monthly meeting over the past six months:

  • May = up 0.25 percentage points
  • June = up 0.50 percentage points
  • July = up 0.50 percentage points
  • August = up 0.50 percentage points
  • September = up 0.50 percentage points
  • October = up 0.25 percentage points

During that time, the cash rate has increased from a record-low 0.10% to 2.60% – still low by historical standards, but much higher than six months earlier.

And the RBA is almost certain to increase the cash rate further.

When announcing its October monetary policy decision, the RBA board said:

“The Board expects to increase interest rates further over the period ahead. It is closely monitoring the global economy, household spending and wage and price-setting behaviour. The size and timing of future interest rate increases will continue to be determined by the incoming data and the Board’s assessment of the outlook for inflation and the labour market. The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that.”

How cash rate rises affect the economy

The logic behind increasing the cash rate to reduce inflation is this:

  • Inflation is caused, in part, by excessive spending
  • Raising the cash rate reduces spending
  • That’s because raising the cash rate leads to higher home loan and business loan interest rates
  • And that, in turn, leads to less discretionary spending from consumers and businesses

Increasing the cash rate also puts upwards pressure on the Australian dollar relative to other currencies. That’s because, as the Reserve Bank explains, an increase in Australian interest rates relative to global interest rates increases the returns on Australian assets. That can lead to greater demand for Australian dollars, as investors shift their funds from foreign to local assets.

Why is that relevant? Because a higher Australian dollar also makes our imports cheaper – which puts downward pressure on inflation.

At the same time, a higher cash rate makes Australian government bonds more attractive to investors, because it leads to higher yields and lower prices for our bonds.

Why the RBA might soon start cutting rates

Right now, the Australian economy is performing strongly. The unemployment rate was just 3.5% in August, while the economy grew 3.6% year-on-year in the June quarter, according to the latest ABS data.

However, storm clouds are on the horizon. That’s because the economies of China, Japan, Korea, America and Britain – our biggest export markets – are slowing. If they buy fewer Australian exports as a result, our economy will suffer.

When the economy is running too hot and inflation is rising, central banks raise official interest rates. But when the economy is cooling and inflation is under control, central banks cut official interest rates. As a result – strange though it sounds – even though the RBA and other central banks are currently hiking rates, they might start lowering rates soon. The futures market is already pricing in rate cuts in late 2023 and early 2024.

What this means for your budget

There are two takeaways for Australian home owners.First, you need to budget for higher interest rates, at least in the short-term. It’s possible the cash rate might increase by another 1 percentage point, although no one can say for sure.

Second, the RBA isn’t going to hike rates forever. There are almost certainly more rate rises to come, but we appearto be closer to the end than the beginning.

If you’re wondering how future rate rises would affect your monthly repayments, Shore Financial would be happy to crunch the numbers for you. Call us on 1300 416 700, email us on info@shorefinancial.come.au or fill in this online form.






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