Inflation & The Cash Rate

Inflation & The Cash Rate – Behind The RBA Decision

It’s hard to think of another single financial factor that generates as much emotion as the raising or lowering of the Cash Rate. If you’re a borrower, you want it to be low, if you’re a saver, like self-funded retirees or people saving for a house deposit, you want it to be higher. It’s just not possible to please everyone.

Today, the RBA took the decision to raise the cash rate by .25% to .35%. This is the first rate rise in over ten years.

Let’s do a little Economics 101, and then take a look at why the RBA has taken the decision they have today.

Managing The Economy

The economy is like a seesaw. If a seesaw had three ends: price stability, full employment, and prosperity & welfare of the population. It is the job of the Reserve Bank to balance that seesaw. The Cash Rate is the key monetary tool the RBA uses to help control inflation, which of course impacts employment and prosperity.

What Is The Cash Rate?

The Cash Rate is set by the Reserve Bank of Australia (RBA) and it refers to the interest rate on unsecured overnight loans between domestic banks. This rate is reviewed monthly and is the primary factor influencing mortgage rates, although competition, risk ratios and broader financial markets also play a part.

Until this afternoon’s announcement, the Cash Rate of 0.1% was the lowest rate on record.

How does The Cash Rate Impact Inflation?

When the RBA Cash Rate is low, lending rates, such as mortgages and business loans, are low too.

When interest rates are low spending increases, as businesses, families and individuals have access to more of their income. Businesses respond to this increase in demand by increasing production, which in turn leads to an increase in economic activity and employment.

When the Cash Rate is high, it is reflected in lending rates, reducing the amount of money people have available for discretionary spending, which in turn impacts economic activity and puts downward pressure on prices and wages.

 Why Target 2-3% Inflation?

In balancing that seesaw the RBA believe that an inflation rate of between 2 & 3% is ideal for maintaining price stability and full employment.

When inflation is too low it can exert downward pressure on wages and employment. On the other hand, when it is too high it can reduce purchasing power, and cause wage blowouts, which in turn leads to higher prices and a reduction in return on investment.

The Current Inflation Rate

Last week the most recent inflation figures were released and it wasn’t good. We have hit 5.1%, which is well above the RBA target range.

In Australia a key indicator of inflation is the Cost Price Index (CPI), which is based on a ‘basket’ of goods that reflect the things Australians spend money on, in categories like transport, food, health, housing, and communication.[i] Obviously, the costs of items in each of these categories changes at different rates, so 5.1% is an average.

Because of this, the RBA also look at what they refer to as the ‘trimmed mean’. This is the middle-performing 70% of expenditure classes from the CPI basket, meaning that those performing above 85%, or below 15% are excluded, effectively taking the middle of a bell curve. Even based on the trimmed mean, the inflation rate announced last week sits at 3.7%. Still well above where the RBA wants it to be.

Income & Inflation

Based on current figures, nominal wage growth in Australia is 2.3%, while inflation is 5.1%. This means, in real terms, wages have reduced by 2.8% over the past year. This goes directly to the heart of one of those ends of the seesaw. The prosperity and welfare of the population.

However, we are beginning to see signs of upward pressure on wages, due to the very low unemployment rate.

 Complicating Factors

There have been a few complicating factors for the RBA to consider when making the decision to raise the Cash Rate.

The fact that an election is so close means that deciding to increase rates may be seen by those on one side of the political divide as biased, while deciding not to increase them will be similarly viewed from the other side of the fence. However, the RBA are always very clear they will make their decisions without concern for political fallout.

The factors behind the inflation rate must also be considered. There’s no doubt the soaring petrol price has had a significant impact, and has had a knock-on effect on the price of transport, thereby affecting the price of pretty much everything. This price rise is driven by the conflict in Ukraine. Factor in Covid-related supply issues and the massive floods in Queensland and NSW affecting food supply, and we are edging towards a perfect storm.

Another factor for the RBA to consider is the employment rate and wages. With unemployment at such low rates, upward pressure on wages will begin to impact inflation.

Today’s Decision

In announcing a rise in the Cash Rate of 25 basis points, or .25%, the Reserve Bank have signaled a belief that the outlook for economic growth in Australia remains positive, despite ongoing uncertainties around the world.

In their statement they have also given clear indication that this is only the first of further rises:

“The board is committed to doing what is necessary to ensure that inflation in Australia returns to target over time. This will require a further lift in interest rates over the period ahead.”

Many experts believe we will be looking at a Cash Rate of around 1.25% by the end of 2022. Great news for savers, but not so great for borrowers.

If you would like advice on how today’s rate rise impacts your financial position, Manly Financial Service have the in-depth knowledge to help. Give us a call on (02) 9976 3388, or contact us via the below link.

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References:
[i] https://www.abs.gov.au/methodologies/consumer-price-index-australia-methodology/mar-2022