A reflection on interest rates

With the constant public focus on interest rates, particularly the first week of every month when the Board of the Reserve Bank of Australia (RBA) meets to determine its movement, many people don’t fully understand the power of the term “cash rate”. Here is an explanation.

In most developed countries, the official interest rate sets a benchmark from which mortgage, credit card and other loan rates are based. If interest rates are “low”, individuals, businesses and governments will borrow to invest or increase consumption. We buy more whitegoods, cars and property whilst companies expand production and governments build more infrastructure. If rates increase, we put off buying and investing and the economy slows down.

Raising or lowering rates is always likely to be controversial because the decision will be based on imperfect data. It takes time for statistics to emerge and show what the economy is doing, and often there are flaws in the data or the figures conflict with each other. Using interest rates as an economic tool is not an exact science.

The problem with growing too fast is that demand outstrips supply and prices start to rise. Signs of this include a shortage of skilled workers, higher prices for raw materials and infrastructure bottlenecks. These problems cannot be solved overnight so the “solution” is to slow the economy to reduce demand. However, raising rates too quickly could trigger a recession; and moving too slowly could allow inflation to get out of control.

A business may decide to defer expansion plans not just because credit is more expensive, rather they see lower demand for their products. Another strategy could be to proceed with expansion plans and try to steal a march on their competitors.

In theory there should be a “neutral” interest rate that will keep the economy ticking along nicely. The Reserve Bank of Australia identifies this is between 5.5% and 6.5% in a healthy economic environment. However, since the Global Financial Crisis the cash rate has been adjusted to stimulate consumer spending and business investment and, more recently, in an attempt to reduce the Australian dollar. The current rate is at an historic low of 2.0%.

How well the strategy works depends on the response of individuals, businesses, the major banks and governments. The economy, after all, is the result of the decisions we all make. A combination of ongoing global uncertainty and ambiguity in our own political landscape is acting as a restraint on Australian consumption and investment despite the low interest rates.

Let’s wait and see what happens next month…