Supply and Demand
What causes a change in interest rates is clear but there is huge complexity in the ways consumers use credit. An increase in the amount of money available to borrowers increases the supply of credit. For example, when you open a bank account, you are lending money to the bank. The bank then lends that money to other customers. The more banks can lend, the more credit is available to the economy. Moreover, as the supply of credit increases, the price of borrowing (interest) decreases.
During the pandemic people had their freedoms restricted and the money that could have been spent on holidays, entertainment and other leisure was saved. Consumers paid off their credit debts and deposited surplus money into mortgages – effectively money was flushing through the economy. Now more consumers are struggling to pay debts and that is affecting the credit available.
The credit available to an economy decreases as lenders decide to defer the repayment of their loans. An example is when you choose to postpone paying this month’s mortgage until next month or even later, you are not only increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market. This, in turn, increases interest rates in the economy.
Inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year. The higher the inflation rate, the more interest rates are likely to rise. Inflation affects interest rate levels because lenders demand higher interest rates to compensate for the decrease in purchasing power of the money they are paid in the future.
Reserve Bank of Australia (RBA)
When the Reserve Bank lowers the cash rate (the market interest rate for overnight loans between financial institutions) other interest rates in the economy to fall. Lower interest rates stimulate spending – because people and businesses can get credit. Businesses respond to this by increasing how much they produce, leading to an increase in economic activity and employment. If the increase in demand is strong enough it can push up prices, and lead to higher inflation. Where we are now!
You might ask why has the RBA let the credit spree go on for so long. Well partly because businesses also borrow and sell more goods that then require more employees. So, it is really difficult because not all consumption is one category of borrowers.
Where are we now in housing finance?
In May 2022 in seasonally adjusted terms, the value of new loan commitments:
- for total housing rose 1.7% to $32.4b, after a revised fall of of 2.8% in April
- for owner-occupier housing rose 2.1% to $21.2b, after a revised fall of 1.7% in April
- for investor housing rose 0.9% to $11.2b, after a fall of 4.8% in April
In May 2022 in seasonally adjusted terms, the value of external refinancing:
- for total housing rose 3.1% and was 16.6% higher compared to a year ago
- for owner-occupier housing rose 2.0% and was 19.9% higher compared to a year ago
- for investor housing rose 5.7% and was 10.2% higher compared to a year ago
We all use credit but not for the same reasons. This balance is difficult because of the complexity of the millions of transactions. When one group has low housing rates the depositors receive meager yields – the inverse is also true. Businesses that cannot borrow cannot expand and that impacts employment and costs of goods. Raising interest rates is a reaction to the millions of transactions in an economy and highlights how difficult it would be to get the balance right – or even if it can be balanced. The old expression cash is king will arguably never lose its lustre.