A second way higher interest rates help calm inflationary pressures in the economy is how they alter people’s decision to save rather than invest.
And by people, I mean not only households, but also businesses.
Generally, higher borrowing costs encourage saving and discourage borrowing to invest. The opportunity cost of spending your money today – rather than saving – will effectively at the top 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 increases due to the amount of extra money you need to invest in interest payments. So you could borrow less.
The effect of these two changes in incentives is to delay purchases – including by businesses – which reduces total demand in the economy.
Why is demand reduction important? Well, remember that the price of everything is determined by the twin forces of supply versus demand; when demand for something drops – all other things being equal – prices also drop. That’s the main thing, at least.
A third important way in which interest rates help dampen inflationary pressures is by reducing the “wealth effect”.
Extremely low interest rates have spurred a massive increase in household borrowing, mainly to finance home purchases. This hurt potential buyers, but left many current owners feeling like their net worth has improved significantly. When you think you are richer, you act differently. You splurge here and there in hopes of being able to use your higher wealth as income at some point, perhaps in retirement.
Soaring asset prices are also encouraging people to tap into the “equity” built up in their loans, either to fund current expenses or to borrow more, perhaps through investment property.
Higher interest rates put a stop to that, making it harder for people to afford to borrow so much and driving up home values. Thus, higher rates reduce part of this “wealth effect”.
Again, this is actually good news for future owners.
Finally, higher interest rates also work their disinflationary magic via their impact on the Australian dollar.
Higher interest rates increase the attractiveness for foreign investors to own assets denominated in Australian dollars. To buy these assets, they have to buy more Australian dollars, which drives up the value of our dollar.
A stronger Australian dollar against other global currencies, in turn, makes our exports more expensive for foreigners to buy, which could dampen domestic production a bit. It also increases the purchasing power of Australian buyers overseas, making imports cheaper and thus reducing some costs.
Basically, it’s complicated. But it works.
Yes, this means higher costs for some mortgaged households. And it will hurt. But the cheap borrowing rates we’ve all grown accustomed to were just too low to last.
The party had to stop at some point. And it’s better now, before inflation sets in.
No one benefits from too much inflation. Inflation erodes the future value of all our savings, which means that a dollar tomorrow is worth much less than a dollar today, which means that we all have to keep working much longer to have the same level of retirement life.
It’s part of the pain now to protect us in the future.
Keep in mind there’s a difference between the Reserve Bank raising interest rates to a level where they really bite into the economy, and just bringing them down to a more normal level where they don’t encourage not a lot of activity in the economy.
Our reserve bank is only targeting the latter, for now.