What’s Driving the Interest Rate Increase in 2023? Unpacking the Mystery for Us Common Folks

Are you feeling the pinch in your wallet? Have you noticed your mortgage payments creeping up? You’re not alone. The Reserve Bank of Australia (RBA) has once again raised the bar, hiking the cash rate by another 25 basis points to a notable 4.35 percent. All we’re asking for are higher incomes and lower interest rates for our mortgages—the single most significant asset—that enable us to comfortably provide for our families, secure a roof over our heads, and afford nice things for our children. Why is the RBA struggling to fulfill such a fundamental expectation?

In her speech as Governor of the Reserve Bank of Australia (RBA) on October 24th, 2023, Michelle Bullock addressed the central bank’s monetary policy and framework. She emphasised the bank’s dual goals: keeping inflation low and stable within the 2 to 3 percent sweet spot, while also fostering full employment. These aims aren’t just bullet points on a policy document—they’re the pillars that support economic stability, providing certainty for households and businesses and fuelling investment and productivity growth.

Forecasts suggest we might not see inflation relax back into its comfort zone until late 2025. So, the big questions loom: What does this mean for you, for businesses, and for the Australian economy at large in 2023? And is there an end in sight for these rising interest rates?

This article will explore the RBA’s reasoning and the wider consequences of a world grappling with escalating borrowing costs. We’ll dissect the policies, analyse the data, discuss the reasons behind the continued increase in interest rates during 2023, and unpack what all of this means for the average Aussies.

1. The Policy Impact – The impact of the Reserve Bank of Australia’s (RBA) policies, as outlined in Governor Michelle Bullock’s speech, particularly concerning the estimated borrowers with the cost of living exceeding their income, reflects the delicate balance the RBA must strike in its monetary policy decisions. The data presented in the speech highlights the financial pressures faced by households,
   especially those with mortgages, as higher interest costs have outpaced the rise in income. This situation underscores the importance of the RBA’s dual mandate of maintaining both low and stable inflation and full employment. While the RBA seeks to stimulate economic activity and job growth by keeping interest rates low, it must also be watchful about the potential risks associated with high household debt levels.
2. Inflation: Inflation targeting is a monetary policy strategy used by The Reserve Bank of Australia (RBA) to maintain price stability within the economy. The RBA has set a target inflation range of 2-3%, aiming to keep the rise in prices within this band. The current cash rate, which is a key tool used by the RBA to influence inflation, stands at 4.35% while the inflation rate is at 5.4%. This inflation rate is above the desired target range. When inflation falls below this range, the RBA might reduce interest rates. Lower interest rates can make borrowing cheaper, thereby encouraging businesses and consumers to spend and invest more, which can help to spur economic growth. On the other hand, when inflation exceeds the target, as it is now, the RBA may increase interest rates. Higher rates can lead to more expensive loans, which might discourage spending and borrowing. This cooling effect on economic activity is intended to reduce the inflationary pressures by slowing down the rate at which prices are rising, helping to bring inflation back within the target range.
3. Employment Rate: The RBA holds a dual mandate, one aspect of which is the objective of full employment. This means the RBA actively works towards a labour market where as many people as possible who want to work can find employment. To influence this, the RBA adjust interest rates. In times when unemployment is high, which suggests that the labour market is struggling, the RBA may opt to lower interest rates. The rationale is that cheaper borrowing costs can encourage businesses to take out loans to invest in new projects or expansion, which can create new jobs. Additionally, lower interest rates can boost consumer spending, which can further bolster business revenues and potentially lead to more hiring.
   
   On the flip side, when the labour market is robust—characterised by low unemployment and increasing wages—the RBA may increase interest rates. This action is taken to cool down the economy. A strong labour market can lead to higher demand for workers, which can drive up wages. While rising wages are beneficial for workers, they can also contribute to inflation if they outpace productivity gains. In such a scenario, higher interest rates can help temper economic activity, thereby preventing the economy from overheating and keeping inflation in check.
   
   As noted by Michelle Bullock, an official at the RBA, and as reported by ABC news, the RBA has set a goal to adjust the unemployment rate to a more sustainable level of 4.5 percent by the end of 2024 from its current rate of 3.6 percent. Given the current low unemployment and upward pressure on wages, it seems improbable that the RBA will lower interest rates in the near future. Instead, it may continue to maintain or even raise interest rates to balance the economic growth with its inflation and employment objectives.
4. Economic Stability: The RBA is not only concerned with inflation and employment but also with the broader aspect of financial stability within the economy. Prolonged periods of low interest rates can sometimes lead to increased financial risk, such as elevated household debt levels or inflated asset prices. These risks can create vulnerabilities in the financial system. For example, if asset prices, like housing, increase too quickly, it can lead to a bubble where prices might sharply correct downwards in the future, potentially causing financial distress.
   
   The RBA, therefore, must tread carefully. It may consider raising interest rates to mitigate such risks. Higher interest rates can make borrowing more expensive, which may slow down the growth in household debt and cool off an overheated housing market. This action can help prevent the formation of asset bubbles that could burst and cause wider economic harm.
   
   Over the last two decades, Australia has seen a significant increase in household debt, largely fuelled by housing finance. This surge in debt, to 4.3 times the level it was twenty years ago, poses a concern for the RBA. With household debt reaching 116.6 percent of Australia’s Nominal GDP as of March 2023, according to CEIC Data, the RBA faces a complex situation. The central bank must balance the need to manage inflation and support employment with the imperative of maintaining financial stability.
   
   Given the current economic landscape, marked by high household debt and the potential of an asset price bubble in the housing market, the RBA’s ability to lower interest rates is constrained. Lowering rates could further exacerbate these financial imbalances. Consequently, the RBA might be more inclined to maintain or increase interest rates to ensure economic stability and to prevent the build-up of financial vulnerabilities that could have long-term detrimental effects on the Australian economy.
5. Exchange Rate: The floating exchange rate of the Australian dollar grants the Reserve Bank of Australia (RBA) the autonomy to adjust interest rates independently from other major central banks around the world. Interest rates are a significant factor in determining the value of a currency. When the RBA raises interest rates, it can lead to an appreciation of the Australian dollar because higher rates tend to attract foreign investment, increasing the demand for the currency. Conversely, lowering interest rates may result in a depreciation of the dollar.
   
   Changes in interest rates can influence the exchange rate, which, in turn, affects export competitiveness and import prices. The RBA may adjust interest rates to manage the Australian dollar’s value and its impact on the economy.
   
   For example, if the RBA wants to boost exports to stimulate economic growth, it may lower interest rates to reduce the value of the Australian dollar, making Australian goods cheaper and more competitive on the global market. On the other hand, if the economy is overheating, the RBA might raise rates to strengthen the dollar and reduce the cost of imports, which can help in controlling inflation.

In summary, the policies and objectives of the RBA have a significant impact on interest rates in Australia, often leaving regular Aussies feeling caught in the middle. Everyone desires higher wages coupled with low interest rates. However, the RBA faces a challenging balancing act in achieving this, as managing the economy involves complex trade-offs and careful adjustments to avoid tipping the scales towards inflation or recession.

Plan of Action for the Readers to Cope with Interest Rates

Understanding the Current Economic Climate

• Acknowledge that the RBA may not reduce the interest rates anytime soon to tackle high inflation, aiming to calm prices and maintain employment.
• Recognise that higher interest rates affect mortgages for your home and investment proeprties, making borrowing more expensive.

Evaluating Personal Finances

• Review your own budget and financial commitments, considering the impact of higher interest rates on your expenses.
• Assess your personal and investment debt levels, especially if you have variable-rate loans for your properties that will be affected by rate hikes.

Planning and Adjustment

• If you’re facing financial strain, consider reaching out to financial advisors or services like Investax for guidance on cash flow management.
• Explore refinancing options for existing personal or investment property debts to secure lower interest rates before they rise further.
• Consider fixed-rate loans to provide certainty in your future repayments.

Long-Term Financial Goals

• Revisit your financial goals and timelines, adjusting them to account for the current and forecasted economic conditions.
• If you’re saving for a home or investment property, factor in the potential for further interest rate increases in your plan.

Staying Informed

• Keep up-to-date of economic updates and RBA announcements as they can give insights into future financial trends.
• Stay informed about your employment sector’s outlook, as it may influence your income stability and opportunities.
• At Investax, we consistently monitor the RBA’s announcements and strive to demystify the information for everyday Australians. Keep yourself up to date with our articles; they offer valuable insights into managing your financial well-being.

At Investax, we recognize the delicate balance that must be struck in your financial life, especially given the current economic climate where rising costs of living and interest rates can make debt repayment challenging. Our expertise lies in helping you understand your cash flow situation and strategically planning for the future. If you find yourself navigating these financial pressures, don’t hesitate to reach out. Let’s have a conversation about your financial health and set achievable goals to secure your financial future, taking into account the economic factors that influence your personal economy.

Reference-

1. Monetary Policy Decision – Statement by Michele Bullock – https://www.rba.gov.au/media-releases/2023/mr-23-30.html
2. Governor Michele Bullock Speech – https://www.rba.gov.au/speeches/2023/sp-gov-2023-10-24.html
3. ABC news – https://www.abc.net.au/news/2023-06-25/the-rba-wants-more-unemployment-lets-applaud-it/102506500

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