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Financially confused??! Rate move.

Discussion in 'The Pub' started by robsalvv, Aug 2, 2006.

  1. Interest rates went up again today - apparently in reaction to inflation going up.

    Ok... I'm confoosed. This makes no sense to me.

    Raising interest rates is meant to take money out of the economy by increasing interest charges [...into who's pocket do these interest charges go?? Should I be buying bank shares!?] so that there's less discretionary money to spend.

    As far as I understand the theory, with less discretionary money sploshing around, the market forces which drive prices up will be softened, and this should keep inflation at bay.

    WTF? Helloooooo???

    Does anyone else see the logical flaw???

    As best as I can tell, the increase in inflation reflects the increase in input costs - namely petrol and bannanas... so this is a cost driven inflation increase, not an excessive demand driven inflation.


    Money is already being sucked out of our wallets because of rising costs... and now everything will cost that little bit more because rates are higher... which will feed back into inflation again... so if a financially savvy netrider could explain to me how pulling on the interest rate lever will help, that would be appreciated.

    I'm a little bit confoosed?!

    ...sorry this sounds like a rant, it's not meant to...
  2. The way I understand it is: If there is less money in the economy, then consumer prices will not be able to rise as much and still allow people to buy their wanted/needed items. Therefore vendors/manufacturers will seek to keep their prices that little bit lower in order to keep selling their products.

    If money stays in the economy, then manufacturers will be able to raise prices at their whim, which when compared with similar items overseas will mean our dollar becomes less valued. (which will then really cause consumer prices to increase on import items)

    I may not be an expert, and my description may not be accurate, but it suffices my need.
  3. I get ya Boz... and that makes sense in a demand driven inflation scenario... but money is already being sucked out of the economy due to rising costs resulting in increased prices which is what's reflected in the increased inflation rate...

    Is my view too simple?
  4. That's how I understand it. As I said - it suffices my need, but not sure how accurate it is.
  5. Not to me. I've been wondering the same thing for a while.

    I wish they'd stop raising interest rates. My bf and I want to buy a house so we're not paying dead money....
  6. Dead money ??? How about the intrest you pay to the bank as if THAT isn't dead money. At least I get something for my rent (a place to live in)

    Don't forget that if you pay back you home loan in 25 years, you have paid the house price back twice. Now you might think it's worth it because house prices keep on booming and capital gains will make you a millionaire, but how long can this continue house prices can't go on doubling every 5-7 years!
    Something is going to break ...

    You are much better off renting, and saving your extra cash.

    robsalvv: bannans have little to do with the rates hike.
    The RBA ignore prices aberrations (like bannans) in their calculations.
    The logic is quite simple costs rise, because money is cheap and demand is greater than supply. Only 2 ways to control this:
    -Reduce demand, unfortuantely for some things like petrol the gvt isn't doing much to help.
    -Make money more expensive then people think twice about buying the stuff they don't need. And business can't put prices up if they want to continue selling.
    Unfortunately some people can't afford stuff they DO need.

    Hence why should 1 should have been implemented, but politicians don't seem to really care.

  7. I agree, but when renting you can't add extra hooks for hanging pictures, you can't pull up carpeting and put down something that you like, you can't revamp the kitchen if it doesn't suit you....

    My point is that it's like hiring a bike for life. You might ride it all the time, but it is not yours. And like you said, house prices keep going up, so saving means sh!t.

    It's not about the money to me, it's about having my own place and being able to make it MINE.
  8. In that case it's different, good luck :)

  9. Nic - you're not really addressing my question.

    Howard was on the box talking about the impact of petrol and what's been driving up the CPI. e.g. Vege's and fruit are up, goods are up, petrol is up etc ... Basically the message is that the CPI is up because input costs are up.


    No one NO WHERE is talking about inflation being driven by demand and cheap money... well not in the stuff I've read and seen.

    So though I agree with you in a demand driven CPI/price rise scenario,
    if we're in a costs driven rising inflation scenario, HOW does raising interest rates help???

    With respect to your "money is cheap" comment, I saw something in the Age on the weekend that said a quarter percentage increase today - given how our economy is structured now, is equivalent of a 1% increase in the bannana republic 90's. Yikes.
  10. Sonja,

    Nic is right about loans and paying them back as per the schedule. Have a play on this:


    At today's rates, paying a mortgage back per schedule over 25yrs means you pay back twice the amount [in absolute, not real terms]. Increase the interest charge and it only get's worse!

    I agree with your point about renting being dead money only when you're renting a decent house all to yourself or yourselves [couple/family]... since the monthly rent is about the same as a mortgage...

    Anyhow, that's a whooole other topic.

    I'm looking to understand the interest rate thing...
  11. Interest rates are pretty complex and there are several schools of though on the correct application of interest rate changes, depending on the type of inflation experienced.

    Rob you are correct in saying that a reduction in disposable income from external cost push inflation should act to reduce inflation… and boz you are correct when you say that the RBA is increases in interest rates to reduce demand and hence inflation

    As already pointed out there are basically two types of inflation
    A) - Demand pull: often caused when an economy is going well, people prosper, they want more goods and services and can pay more for them. As a result prices go up.
    8) – Cost push: True cost push inflation only happens when costs increase without any influence from demand. Oil price increases in Australia are probably a good example. Increases in wages (often a significant factor in inflation) are sometimes really a demand pull event (people prosper and demand more good and services, more people are required to produce these goods and services resulting in a labour shortage and labour costs increase)

    But there is also another “quasi” category of inflation:
    c) – Wage/price spiral or inflationary spiral – this can start with either cost push or demand pull inflation. Prices increases and employees demand higher wages, if unemployment is low and employees have some power they will get a wage increase. Now wage costs have increased for business and goods and services cost more…..so the whole cycle starts again.

    Before one can understand why interest rates have increased in Australia one needs to understand what is really driving. I don’t have the answer to this but I suspect there is some demand pull inflation (as the economy is going reasonably well and unemployment is low) and a fair bit of cost push inflation (in particular from oil).

    So what should the government do?

    For demand pull inflation interest rate rises work well. They reduce disposable income which reduces demand and hence prices. There will be some pain as certain industries contract and unemployment may rise but ultimately this is much better than an inflationary spiral. Reductions in government spending can also be used here but that's a different topic.

    For cost push inflation (and in particular oil price increases) the solution is much harder. If oil price increases are the only inflationary factor acting on an economy some experts would argue the best solution is to do nothing. Prices will rise, incomes will fall, demand for other goods and services will fall and so prices of many consumer products will fall (even if the cost of making these products increase). Businesses will get squeezed, unemployment will increase which will further reduce demand and control inflation.

    Unfortunately where it gets more nasty is when you’ve got cost push (e.g. from oil) and demand pull inflation happening together. If this happens consumers are better able to bear short to medium term increases in prices that flow from oil price increases. Instead of being forced to cut costs (or whatever else they can do) businesses just increase prices, then workers demand pay increases (which they get because unemployment is really low) and people continue their spending. Businesses now have a higher cost base and the inflationary cycle continues.

    In this situation an interest rate rise can be required to put the breaks on household spending to make sure demand for goods and services falls before things get out of control. I suspect that the RBA has made an assessment of the type of inflation and state of the economy and done what it hopes is best for the economy.

    The whole oil issue is a worry though. We won’t have a solution until a new sustainable fuel source can replace fuel in daily life. I saw a research report a couple of weeks ago called “the next great depression”. It was an article about what will happen to economies as oil runs out.
  12. Thankyou for a really excellent response to the topic. :) :applause: Really appreciate that! You've enlightened me.

    Some good discussion I heard on the radio last night pretty much confirmed that there's both a push and pull going on and that my view was a bit too simple... the interest lever is too blunt though... business overdrafts, credit cards, hire purchases, car/truck/bike/house/personal loans... even if you don't run a card or have a loan... the impact will wash through.

    There already is some shakedown going on from previous rises - apparently mortgage defaults were up 50% last month compared to some time in the past...

    A really interesting number I saw last night showed that when interest rates were at ~17%, the repayments on the average loan was ~26% of income... today, at 7.x% the repayments on the average loan is ~28% of income...

    Interesting times...

    Thanks again Katherine. :)
  13. Which leads straight into this thread

    The only explaination I can think of to explain that is everyone has taken out a larger loan with the lower interest rate in place......thats going to hurt as the interest rates go up....and further explains such a high rates of default on the loan.
  14. One of the ways to avoid some of this is to pay 1. weekly, 2. more than you need to or 3. throw any extra cash into the mortgage ...... but of course, with the numerous rate rises in the past 12 months that has become increasingly harder in its self :(
  15. I think that's pretty much true. But it also means the RBA wont have to raise interest rates much to achieve the desired impact on the economy (i.e slow discretionary spending). Given today's level of average household debt an interest rate of 17% would have some pretty terrible impacts on the economy and that's not the goal.

    There is also a flip side to high interest rates in that they are not bad for everyone. People of our age group who have mortgages that they can't just pay out will suffer, but many of the baby boomer generation who have paid off their houses will be net savers, not net borrowers. People in this group will benefit from higher fixed interest rates, etc. Now if only I could do something about that home loan :p

    Oh yeah, historically banks don't usually benefit from high long term intrest rates (not so sure about moderate rates). They receive more interest from loans (mortgages etc), but they have to pay their deposit holders more. Plus in an environment of high rates net borrowings will decline as few people are willing to take out loans so over time interest income will fall relative to interest payments.
  16. that's the EXACT reason interest rates go up - to stop people borrowing money.
  17. Dead right! Every extra bit shortens the loan!

    At todays interest rates (~7.5%), increasing the minimum repayment by 0.3% of the principal, e.g. $600/month on a $200k loan, will HALVE the time to repay the loan and just under HALF a house is saved in interest charges. Them's good savings! (Yeh I know, that's quite a bit extra to cough up... I'm just talking figures - no judgements cast or assumed.)

    Sorry, forgot to mention that! Good pick up.

    Good point. I look forward to being on the flip side!
  18. Input costs are up because demand is greater than supply and people are greedy

    More people want fuel than they can pump (or so they say)
    More people want iron than they can dig ...

    And large companies who HAVE to keep on producing better results every year have to get the cash from somewhere so they put prices up knowing very well that people can borrow.

    The RBA and their rate hike just TRIES to but things back into shape, people have less disposable income so goods produces have to do something else other than simply passing the cost across if they want to continue selling thei stuff.

    It's a bit of a simplistic view because their are other factors involved like exchange rates and foreign debt , for example on top of what I have said the if the global rate trend is UP like it is now, we will follow along no matter what.

  19. Nic, thanks for that. All clear now... I think?!
  20. Yeah, it sux in that respect, but waiting to buy a home seems futile at this point.

    I really don't know the market or anything, my bf does, so I'm pretty much leaving the money side of it to him.