The interest rate rise we had to have and how it will help

A second way in which higher interest rates help to cool inflationary pressures in the economy is the way they change people’s decisions to save versus invest.

And by people, I mean not just households, but also businesses.

Increased interest rates may see the Australian dollar appreciate against other currencies.Credit:Lauren Vadnjal

Generally, higher borrowing costs are an incentive to save and a disincentive to borrow to invest. The opportunity cost of spending your money today – rather than saving – effectively goes up because you could instead put it in the bank and earn higher interest than before. So, you save more.

And vice versa. The cost of borrowing to invest also goes up because of how much extra money you have to plow into interest payments. So, you might borrow less.

The effect of both these changes in incentives is to delay purchases – including by businesses – which reduces total demand in the economy.

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Why is reducing demand important? Well, remember that the price of anything is determined by the twin forces of supply versus demand; when demand for something falls – all other things being equal – prices also fall. That’s the gist, at least.

A third and important way that interest rates help to cool inflationary pressures is via a reduction in the “wealth effect”.

Ultra-low interest rates have spurred a massive ramp up in borrowing by households, mostly to fund property purchases. This has hurt potential buyers, but made many current homeowners feel like their net wealth has vastly improved. When you think you’re wealthier, you act differently. You splurge a little here and there in the expectation you can use your higher wealth as income at some point down the track, perhaps in retirement.

Ballooning asset prices also encourage people to tap into the accumulated “equity” in their loans, to either fund current spending or borrow further, perhaps via an investment property.

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Higher interest rates put a stop to some of this, by making it harder for people to afford to borrow as much and push up home values. So higher rates diminish some of this “wealth effect”.

Again, that’s actually good news for aspiring homeowners.

Finally, higher interest rates also work their dis-inflationary magic via their impact on the Aussie dollar.

Higher interest rates increase the appeal to foreign investors of owning Australian dollar denominated assets. To buy those assets, they need to buy more Aussie dollars and so this pushes up the value of our dollar.

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A higher Aussie dollar relative to other global currencies, in turn, makes our exports more expensive for foreigners to buy, potentially dampening domestic production a little. It also increases Aussie shopper’s buying power abroad, making imports less expensive, and reducing some costs that way.

Basically, it’s complicated. But it works.

Yes, it means higher costs for some mortgaged households. And that will hurt. But the bargain-basement borrowing rates we all got used to were simply too low to last.

The party had to stop at some point. And it’s better it does now, before inflation takes hold.

No one benefits from too much inflation. Inflation erodes the future value of all our savings, meaning a dollar tomorrow is worth much less than a dollar today, which in turn means we all have to keep working much longer fund the same standard of living in retirement.

It’s a portion of bread now to protect us into the future.

Keep in mind there is a difference between the Reserve Bank raising interest rates to a level where they are really biting into the economy, versus simply restoring them to a more normal level where they aren’t wildly encouraging activity in the economy.

Our Reserve Bank is only aiming for the latter, for now.

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