Interest rates… but interesting

Speaker 1: [00:00:34] From Equity Mates media. This is the dive. I'm your host, Sascha Kelly. Interest rates don't switch off. I know it sounds boring, but it's really important. When people tell you that something is important. Eating your vegetables, drinking three litres of water a day. Making sure you move for 20 minutes. We all tend to switch off. We don't want to be lectured to. But just like any of these things, there is a valuable reason to have an interest in interest rates. And wherever you're listening to this, you're probably reading the same headlines. I am. Interest rates are rising, but how do you make sense of the paragraphs, the charts and the jargon that follows? If you've never bothered to find out just what interest rates do, it's Wednesday, the 4th of May. And today I want to know why does it matter that interest rates are rising and how is it going to affect me? To do this, I'm joined by my colleague, Darcy Cordell. Darcy, welcome. 

Darcy: [00:01:30] Thank you, Sascha. Nice to be here. 

Sascha: [00:01:31] So, Darcy, we're talking about interest rates because last night Australia's central bank met to discuss them and decided to move them upwards for the first time in a really long time. Before we delve into that topic, I'd like you to give me interest rate 101. What are they? 

Darcy: [00:01:50] Okay. Interest rates are essentially the cost of borrowing money. So Sascha we get paid on Monday next week. 

Sascha: [00:01:56] We do. I'm really excited. 

Darcy: [00:01:58] And I know that Harry Styles is coming to Australia for a tour. Here's a you interested in going? 

Sascha: [00:02:04] I am definitely interested in seeing Harry Styles live there. 

Darcy: [00:02:07] With me here. We're going to assume that his tickets cost $100 and you're running a little bit low on money at the moment. 

Sascha: [00:02:13] Those things may or may not be true. 

Darcy: [00:02:16] So I'm willing to lend you $100 to buy a ticket today. 

Sascha: [00:02:19] Because you know that I'm short on funds. So you're going to spot me today to make sure that I get one of those tickets. 

Darcy: [00:02:24] Exactly right. But I want a little bit of a guarantee that I'm going to get some money back in return. So let's say I'm going to ask for $110 back from. 

Sascha: [00:02:33] You, and I'll definitely justify my $10 in interest if it means I'm guaranteed to see Harry. After all, if I wait, I might miss out.

Darcy: [00:02:40] But let's assume interest rates rise 10%. That means that you are already paying me back $110. But now that interest has jumped another 10%, I'm going to have to ask you to pay me closer to $120. Are you still willing to make that trade? 

Sascha: [00:02:55] I mean, I've got to ask some questions about why you're charging me interest to lend me money anyway. I'm pretty good at paying people back. 

Darcy: [00:03:03] You're the glue that holds this operation together. This example is oversimplified, but usually it's the bank passing on these interest rates. And when the interest rate that the bank borrows out increases, they pass that on to us as consumers. 

Sascha: [00:03:16] So I understand then the bank is setting my interest rates because that's who I'm engaging with. Who sets the interest rates for the banks? 

Darcy: [00:03:25] Interest rates are generally controlled by the central bank of a nation. So here in Australia it's the Reserve Bank of Australia, the RBA, in the US it's the Federal Reserve and in the UK, the Monetary Policy Committee. 

Sascha: [00:03:36] And this is why we're talking about interest rates today. The Reserve Bank of Australia met yesterday and raised the cost of borrowing for all Australian banks. How much did they raise it by? 

Darcy: [00:03:47] So they've raised interest rates from 0.1% to 0.35%, a quarter of a percentage point jump. It's the first increase in over 11 years. 

Sascha: [00:03:57] I don't want to be finicky, Darcy, but 0.120.35. That doesn't seem like a lot. And you told me this story was really important. I can imagine that they can afford 0.35% interest, especially when I look at mortgage rates and they all have at least a three in the first column. 

Darcy: [00:04:17] It's a good point, Sascha, but this story's not important because the banks have to pay a little bit more. It's actually going to be good for bank profits. But that's another story. This is all about the consumer. And Sascha, we've just done our version of interest rates 1 to 1. But to check, I wasn't leading you astray. I asked the same question of Gigi Foster, a professor of economics at the University of New South Wales. 

Gigi Foster: [00:04:39] Interest rates are basically money you have to pay when you borrow a large chunk of money, oftentimes for a mortgage or something like that, to the entity that loaned you the money, that's all that it is. So an interest rate is kind of like a price of money. And what happens when the Reserve Bank of Australia raises or lowers rates is that our banks, which have to balance their books at the end of every trading day, have to do so at that rate, at the what we call the cash rate, which is the thing the RBA can just have complete control over setting and that means that the banks themselves then have to pay whatever the interest rate is in those little overnight transactions. And most banks will then pass through, particularly a rate rise to their customers who are on variable rate mortgages or other kinds of loans. And so that's why we expect that when the RBA raises a rate, as it has just done, that that is going to percolate through. Too, particularly the real estate market, but also to any other kind of money borrowing situation in the economy, because most money borrowing happens through banks. 

Darcy: [00:05:41] So you can hear from JJ that it's going to have implications to any of us who are customers of banks, which I'm going to assume is most of us. This story is important because of what it means for us as consumers. 

Sascha: [00:05:51] Okay, let's put a pin in that for just a moment. But as I understand it, we have been talking about how this is a global story. Australia isn't alone in raising rates, right? 

Darcy: [00:06:01] They're definitely not alone. Around the world, interest rates are at historic lows, but they're starting to slowly rise. In the US, rates were rise from 0.25%, 2.5% in March. 

Gigi Foster: [00:06:13] After holding its benchmark federal funds rate. 

sound clip: [00:06:15] Near zero for seven years. The U.S. Central Bank has signalled it will begin gradually raising interest rates. 

Darcy: [00:06:22] In the UK there have been two rate rises from 0.25, now up 2.75%. South Africa has raised rates and South Korea has also raised rates. 

Sascha: [00:06:32] So that's a bit of a global tour. It's definitely happening all over the place. 

Darcy: [00:06:36] Yeah, there are a couple of exceptions. China is the big outlier due to their economic circumstances and ongoing COVID zero policy. There's pressure for the world's second biggest economy to cut interest rates. But outside of China, the story around the world is the same. Years of low interest rates and they're starting to slowly rise. But it is slow. 

Sascha: [00:06:55] Okay, Darcy, I think I understand the concept of interest rates now, but a little birdie has told me that this has a close association with another I-word, and that is inflation. Can you get me up to speed on why these two things are associated? 

Darcy: [00:07:10] Yeah, you're right. Inflation and interest rates are certainly connected in some ways. Last week Australia reported annual inflation of 5.1%, the highest level in over 20 years. What does that mean? The price of a basket of goods, including food, transport, health care and housing has risen 5.1% since this time last year. And this all trickles down to us. 

Gigi Foster: [00:07:35] So when it gets more costly to ship things, to make things, you know, to to find workers, to to produce things or to make services, then that that means that the cost to the consumer of whatever that final good or service is is going to rise. So that's inflationary right there.

Sascha: [00:07:50] Darcy You don't need to tell me that inflation is real. I'm looking for houses at the moment, and that rent price is just slowly creeping up. But we talked about the global trend in interest rates. I'm assuming inflation is also a global trend.

Darcy: [00:08:04] It is. It's running rife in some places. In the US, annual inflation is at 8.5%, the highest level since 1981. In the UK it's around 7% and in Brazil it's over 11%. 

Gigi Foster: [00:08:17] We buy products and services from those places as well and so we will have to pay more money for them. And so the inflation percolates along with the effects in the real economy. And one. 

Darcy: [00:08:26] Of the most effective tools that central banks use to kerb this inflation is rising interest. [00:08:31][4.9]

Sascha: [00:08:32] Rates. So these are how these two things are connected. Central banks are making it more expensive for retail banks to borrow money in order to slow down the prices of goods and services rising in the economy.

Darcy: [00:08:45] That's right, because banks take that money and they lend it to us as consumers. If they have to charge a higher interest rate, consumers are going to borrow less, spend less and save more. This lower spending is going to slow down the price rises that we're seeing in economies around the world. But let me be clear. Inflation isn't supposed to be at 0%. It's actually healthy to have some level of inflation, but it is higher than the gold round, which was explained to me by Marcus Brukner, a professor in economics at ANU. 

Gigi Foster: [00:09:15] The Reserve Bank of Australia, reacted to that and therefore raise policy rates so that the inflation rate in Australia is consistent with the target that it has, which is about 2 to 3%. 

Sascha: [00:09:25] Okay. So let's get specific and talk about examples of how this is going to affect me as an individual. What does it mean when banks pass interest rate rise onto me?

Darcy: [00:09:37] There are two ways that bank interest rates affect us. The first, when we save our money in a bank account, savings account or term deposit, the banks pay us interest. Our interest rate is about to rise. So we're actually going to receive a little bit more money if we're holding our money in the bank.

Sascha: [00:09:52] And so this is when you're talking about those high interest savings account where I used to get quite significant returns, but it's been dismal for years now. 

Darcy: [00:10:00] That's right. The banks should be passing on a little bit of an increase in interest to us. And the other side of the coin is when we borrow money from the bank. Sascha, I know you love Architectural Digest. And I saw recently Vanessa Hudgens home is up for sale. Have you noticed? 

sound clip: [00:10:15] Hey, lady, I'm Vanessa Hudgens. Welcome to my home. Come on in. 

Sascha: [00:10:20] Darcy. I had an alert on that house. I think I can see where you're going with this. If I had the hypothetical money to buy my dream home that Vanessa Hudgens had on the market. 

Darcy: [00:10:31] That's exactly. Where I'm going. So her home was worth $9 million. Let's assume she took out a $5 million loan to help her boss. With interest rates at 0.1%, Vanessa would need to pay back $5,000 per month for her mortgage, so I'm sure that's pretty manageable for her. But with a 0.25% increase in interest rates, it'll take the rates up to 0.35% per month. And that's going to increase her monthly repayment by 12 and a half thousand dollars to a total of 17 and a half thousand per month. 

Sascha: [00:11:03] I like how, even in this example, Dorsey, you've taken the ownership of me and this house because, you know, I can't find this 17 grand in my bank account to pay for my home. It's alright. I'm going to keep dreaming, but I can see what you mean now. Once interest rates rise, it does have an effect on your bottom line. 

Darcy: [00:11:20] Yeah, it has a flow on effect and this is an extreme example. But generally if you're a homeowner with a mortgage, higher interest rates aren't exactly welcome. But as we mentioned, for people who are saving money in the bank and don't have a mortgage, higher interest rates can actually help you earn more interest and save a little bit more money. 

Sascha: [00:11:37] Alright, Darcy, you've got me up to speed with interest rates and inflation. We're going to take a quick break. And then when we come back, you've talked to some economists to understand how the rise in interest rates affects us. 

Sascha: [00:12:18] Welcome back to the dive. I'm here with my colleague Darcy, and today we're talking about the rise in interest rates. Darcy You've been talking to some experts. What did they think about this? 

Darcy: [00:12:27] Opinion is a little divided. I spoke to Marcus here, who gave his opinion on why interest rates needed to go up, the. 

Markus Brueckner: [00:12:33] Increase in the interest rate of the 25 basis points. It's, in my view, well warranted given what has happened in the world. So it's largely due to a change in external conditions. And with that, I mean, for example, the rise in commodity prices that's due. I mean, if we think about food, agriculture, commodity prices and also oil, gas prices, it's largely due to an external event that occurred in the Ukraine and what's going on there. 

Darcy: [00:13:02] So those are the reasons that Marcus is attributing these rises to. But other economists have different opinions. 

Gigi Foster: [00:13:07] What we're facing right now is really the harvest of two years of economic mismanagement around the world, including in Australia, but not just here, also in the U.S. and many of our nations, poor nations in Europe. And what has happened all over the place is massive stimulus, very free money policy, and also just large amounts of fiscal outlay. That means just money printing by the government to try to prop up the economies that the government decided to put into a coma. And that basically has a price. And so that kind of mismanagement is now catching up with us. And we always knew that it was inflationary to print and print and print money when there wasn't the economic activity increase to absorb that money. And it's just been a while coming. 

Darcy: [00:13:50] So we've got two very different opinions here. The first is that this rise in interest rates and inflation has been a reaction to global events. And the second is that it's been as a result of mismanagement of the economy. But whatever the explanation, it doesn't change the fact that they've gone up. 

Sascha: [00:14:06] That's a very good point, Darcy. And here's my big question. We've raised them once. Is that going to be it or are we going to raise them more?

Darcy: [00:14:13] I asked that question of economist John Quiggin from the University of Queensland. 

John Quiggin: [00:14:17] I expect that we will see a steady, steady increases with the rate going at least to 1.5% over the course next year.

Darcy: [00:14:25] And Marcus also had an opinion saying that if you read the statement released by Philip Lowe, it's inevitable and suitable. 

Markus Brueckner: [00:14:32] He said that it's very likely that that interest rates will go up in order to keep inflation within the target. 

Sascha: [00:14:39] So he did talk a little bit earlier about what a rise in interest rates and a rise in inflation means for us. But what do the experts think about this? 

Darcy: [00:14:47] Let's look at the impact on us as individuals first. And when I was talking to Marcus, he said, you've got to break it down even further and think about whether you're a saver or a homeowner. Okay. As someone in debt.

Markus Brueckner: [00:14:59] Those those who want to borrow when the interest rate goes up, that means that the costs of borrowing, the interest payment cost increases. On the other hand, on the same side, they benefit. So there's a distributional effect, a very classical distributional effect. And it goes in the way that when interest rates rise, savers benefit. 

Sascha: [00:15:18] Can you translate a little bit of that economic speak for me?

Darcy: [00:15:22] Let's go back to our Harry Styles Tickets example. If it's cheaper to borrow money, you can borrow more. You might have been able to afford that original ten point interest, but because of personal circumstances, that extra ten or $11 might be too much for you to handle. And this is the real world impact of rising interest rates. 

Gigi Foster: [00:15:39] The median household mortgage repayments in Australia will go up by something around 150 bucks a month. So 150 bucks a month may not sound like a lot, but that's actually a weekly grocery shop for quite a number of Australian families. And so it's not insignificant. 

Sascha: [00:15:55] It seems like future interest rate rises might be inevitable. That's got me feeling a little bit nervous. Darcy I've got to admit what I've picked up from this episode, and your explanation is there seems to be a lot of things that I can't control but directly impact me. And they're so linked as well. Interest rates and then rising inflation and how that implicates the cost of my rent. The cost of my groceries, the cost of my petrol. What happens next? 

Darcy: [00:16:22] You're right, Sascha. There is a pretty immediate impact on people who have a mortgage or on those who have debt. But there is a lag on the wider economy. And when I talked to Marcus, he explained that brilliantly. 

Markus Brueckner: [00:16:33] It's not within the same month when just the sector. So for example on inflation it takes about the time series estimate shows it takes about 1 to 2 years until the peak effect occurs. 

Darcy: [00:16:44] And for the Australians listening, Marcus feels really positive.

Markus Brueckner: [00:16:47] In my view, the Australian economy is in very good shape. I think that for the average Australian citizen, life is going to be great no matter what. 

Sascha: [00:16:55] Well, thanks, Darcy, for getting me up to speed on interest rates and their effect on inflation today. Any closing thoughts from you?

Darcy: [00:17:03] I think it's important to understand it's not doomsday, Sascha. Interest rates are still really low relative to the past, but it does come in a time of uncertainty. There's high inflation. Stock markets have been. Taking a beating. And we're seeing signs of house prices declining in major cities, too. So it's something to keep an eye on. But I think we can feel pretty positive about the overall outlook for us here in Australia at least. 

Sascha: [00:17:26] And I can feel positive that I can read these headlines and understand these charts now and keep up to speed with the conversation. Thank you so much for joining us for today's edition of The Dive. If there's a story that you want us to talk about, contact us. The dive at Equity Mates dot com or shoot us a message on social media. We're going to be back in your feed later in the week. In the meantime, thank you so much for joining me today, Darcy.

Darcy: [00:17:50] Thank you, Sascha. Interest rates of fun.

Sascha: [00:17:52] Until next time