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Loading ...Taming the Inflation Dragon and Understanding why the Reserve Bank must increase Interest Rates
March 10, 2008 by Josie Kay
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Don’t worry, I am not about to give you a lesson in economics. I am asked this question quite often and thought I would try and address it as simply as possible.
I can totally understand why most people are baffled as to why the Federal Reserve Bank of Australia raises interest rates when many home owners are struggling to pay the mortgage, have high petrol bills and groceries seem to be getting a lot more expensive.
Why do they have to inflict more pain? One reason is that the Reserve Bank’ is very concerned that inflation is above their target band of 2-3%pa. The latest inflation figure released revealed that the underlying inflation rate was 3.6%pa which was a shocker. The experts are saying that interest rates will have to rise again in March.
You might then be asking, what is the big deal about inflation! If inflation gets out of control, things can get a lot worse. Let’s just imagine that your salary was $1,000 per week and you normally spend $200 per week to put food on your family’s plate.
Imagine if next week, the same basket of groceries cost you $400 but your salary stays the same at $1,000 per week. So last week you could afford $200 of groceries, but the following week, you can really only afford to purchase half the items.
Obviously, this will make you very angry, so now you go to your boss and demand a pay rise. He gives you a pay rise of $1,000 per week, which makes you very happy - you are now earning $2,000 per week and you can afford the same basket of groceries.
Now ask yourself this question? What will your employer do to recoup the extra $1,000 he is now paying you! He must of course pass this extra cost to the people who are purchasing his goods and services, so the vicious cycle starts again. It is interesting that the politicians have set an example and limited their pay rises.
The last thing Australia needs is unusually high pay claims as this will only feed the inflation dragon. Labour costs are a huge expense to businesses.
Ultimately, their goods and services will be too expensive and they will not be able to sell them. To put is bluntly, they will have to reduce their workforce and sack some of their employees.
Inflation is a very complex subject, but to sum up, inflation hurts the general population. When prices rise, we can\’t buy as many things with our money. Pensioners and people on a fixed income are especially hurt, since the things they need to survive have increased in price, but their incomes don\’t increase. Businesses are hurt, as they can\’t invest as much in the business, and it\’s difficult to plan for the future if you don\’t know what the value of the dollar will be.
Even though it very painful when interest rates increase, it is currently the most effective tool that the Reserve Bank has to put the brakes on rising inflation.
MoneyOrganiser Tip: Make sure you can afford at least a 3% interest rate rise if you are about to take out a loan. A bit of trivia – the inflation rate in Zimbabwe is currently around 100,000%pa! (not a typo). They need wheelbarrows to carry their money. The Germans had a similar problem after World War I.
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Hi Josie,
I love your site!
I have a question regarding this article on inflation… I was having a discussion about this the other day with a friend and they reckon we should have a six month price freeze as well as a wage freeze…ie freeze the cost of everything (food, petrol, services)…the idea being to allow the economy to catch up. Personally, I don’t understand how this would help anything? What do you think? Also how bad do things get before its like the Germans after WWI?
Josie’s response: Your friend’s suggestion is good in theory. Your people could talk to my people and we could all agree that we won’t ask the boss for a pay rise or increase the price of any goods or services that we might produce. Apart from everyone thinking we have joined the Communist Party, it simply would not work in a capitalist and free market economy.
Imposing wages and price freezes means there would need to be a lot of government intervention. On top of this we are now well and truly part of a global economy, so it would be impossible to get everyone around the world to agree (but don’t let that stop you from wishing for world peace in our lifetime). Australia does have a wages commission but they are there to protect the lower paid workers.
They also have the difficult task of trying to assess what impact their decisions will have on the economy. At the moment, they would be feeling very sorry for workers on the minimum wage, but it would be very irresponsible of them to grant any significant pay rise (as much as the ACTU would like anyway).
Economists and politicians have been trying for centuries to make it fair and equitable for everyone and still we have no answers. There are many factors affecting inflation at the moment, a major one being that we have been very silly with our spending habits.
If we all agree that we will save more, then perhaps things will settle down. Re your comment on the Germans during World War 1, they had hyperinflation, where prices were doubling every 49 hours.
Now that is scary! Liz, thanks for loving my site. I would be really chuffed if you told your friends, family and workmates about http://www.askjosiekay.com where you get free financial advice by a Certified Financial Planner without the sales pressure. Cheers and happy money organisation.
Josie Kay’s last blog post..I earn $55K. Do I have to pay the Medicare Levy Surcharge of 1%
Hi Josie,
Thanks heaps for the reply and I’ve already put my family and friends onto your site…..I have another question for you….and it’s regarding something you said in your reply:
“There are many factors affecting inflation at the moment, a major one being that we have been very silly with our spending habits”
Would you say that things like “24 month interest loans” are one of the major factors affecting inflation at the moment?
Liz
Liz’s last blog post..Get Rid of Obesity Once and For All?
Josie’s response: I have no doubt that the ‘buy now, pay later’ mentality has fuelled inflation. Unfortunately, it is now so entrenched in our lives that I can’t see them banning it. Ultimately we are all responsible for our own actions. It never fails to amaze me how many people get sucked in by the marketing. As they say, there is no such thing as a free lunch. There is also no such thing as ‘interest free’ loans. The big, profitable finance companies know that a large percentage of people will fall behind in their repayments and then like vultures, charge an arm and a leg in interest. I have heard figures like 30%pa which is a blatant rip off. Perhaps I am being a little old fashioned, but the way our grandparents did it, makes the most sense. Pay cash. If you don’t have the money, don’t buy it.
Money is 80% emotion, 20% logic. A wealth creation tip I regularly share with my radio listeners is to think about how much you are giving up in the future. For example, if you didn’t spend that $1,000 on the latest gadget and instead invested it, earning 7%pa, it would be worth nearly $4,000 in 20 years ($3,870 to be precise). You could direct it to your home mortgage and save lots of interest. So play the compounding interest mind game - every time you purchase something, quadruple its value. All of a sudden you understand the consequences of spending money on frivolous items. Have fun. Josie
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At least y’all’s bank is RAISING the interest rates! Here in America the rates keep falling, which hurts anyone who is trying to save money (a novel concept here now) and we are starting to feel the inflation in food and gasoline prices. Ironically, the powers-that-be don’t use food and energy prices when figuring “official” inflation figures, so the problem is hidden in the math tricks. I just had to up the budget numbers for groceries and gas for April, and am not happy about it.
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Thanks for your comments and it is lovely to receive a comment from the other side of the world. The US is such a powerful economic powerhouse, that we Aussies watch you very closely. We have a saying that when the US catches a cold, we get the flu! In terms of interest rates increasing, it all depends on what side of the fence you are sitting. If you are a home owner with a large mortgage, it hurts a lot when interest rates increase. Of course if you are relying on income from your savings, it hurts. I found it very interesting that the US doesn’t include energy or food prices in the official inflation figures. I think we also use smoke and mirrors with our figures, and have two inflation rates, headline and underlying. Underlying excludes the volatile items, which can iignore petrol and some food items (e.g. floods caused prices to increase). Our Reserve Bank tends to take the underlying rate more seriously than headline. Our inflation rate also includes electronic items such as plasma TVs which have decreased in value, so our underlying inflation figure is around 3.6% at the moment. I believe that if we excluded electronic items, it would definitely be a lot higher (who is buying a plasma TV regularly!). In the real world, it is the everyday items that count, such as food, petrol and housing. Josie
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Even though inflation is now running at around 5% per annum, the Reserve Bank have other major pressing issues to think about - a global recession (hopefully not depression).
However, it is madness ignore it completely. It erodes asset prices and will only make things worse. I am assuming that it will take care of itself because of low demands.
Glad I don’t have the job of Governor of the Reserve Bank!
Cheers
Josie K