Interest Rates to go UP

[a_unique_person]

Following the orthodox economic theory, that is, when inflation goes up, interest rates should go up, Australia is due to raise interest rates.

That is because inflation is rising due to increased fuel prices and banana prices. (well, that's the story, anyway).

However, I fail to see how this works. These price rises are due to externalities, not an issue with the actual Australian economy. All this will do is raise the cost of living for people who are already cutting back on consumption. For those already committed to loans, and hurting, they are just going to hurt more.

The only people likely to suffer the desired effect would be those who would be tempted to borrow to cover the rising prices. Which is a blunt instrument to use to make an effect on a limited part of the economy.

 

[Bob Klase]

For those already committed to loans, and hurting, they are just going to hurt more.

For those already committed to loans, the interest on their loan stays the same. When interest rates go up, the interest only goes up on new loans that you're not already committed to. The exception would be adjustable rate loans and they're almost always on home mortgages. If you were stupid enough to get an ARM then when interest rates go up maybe you'll learn to refinance at a fixed rate before they go up again.

 

[pgwenthold]

For those already committed to loans, the interest on their loan stays the same. When interest rates go up, the interest only goes up on new loans that you're not already committed to. The exception would be adjustable rate loans and they're almost always on home mortgages. If you were stupid enough to get an ARM then when interest rates go up maybe you'll learn to refinance at a fixed rate before they go up again.

We have an adjustable rate on our 2nd mortgage, but it is for a reasonably small amount so we ultimately aren't paying a lot of interest (more than we could, probably, but not worth the cost of refi)

OTOH, in recent years when mortgage rates have been so low, it seems pretty silly to do an ARM considering that it was pretty clear they would be coming back up at some point. When you can lock in at 5%, why bother with the risk of an ARM to get 4%?

 

[drkitten]

Following the orthodox economic theory, that is, when inflation goes up, interest rates should go up, Australia is due to raise interest rates.

That is because inflation is rising due to increased fuel prices and banana prices. (well, that's the story, anyway).

However, I fail to see how this works.

It works because inflation eats into the buying power of future money.

Uncertain money is worth less than certain money. Let's say that I have bet $1000 with someone on a 50/50 payoff (and I've already made my stake). There is a 50/50 shot that this time next month, I will have $1000 and an equal shot that I will have nothing. But I need money now, so I will sell my interest in the bet to you. How much would you pay for it?

You'd be a fool to pay me more than $500 for it, since you've only got a 50/50 chance of getting anything at all from it. (You've actually got slightly less, depending upon how honest I and my betting partner are).

Similarly, if you loan me $1000, payable in a month, you will want more than $1000 (say, $1010) back just to cover the risk that I might stiff you and disappear to Guam or something. Even without worrying about "profit," you need to charge some interest just to break even against the possibility that I might not repay.

Now, when you add inflation into the mix, you also see that the future money is worth less. $1000 today might be "worth" only $950 in a year, meaning that the basket of groceries you buy today for $950 will cost you $1000 in a year. Equivalently, this means that you will need to get me to pay $1000 in a year to break even with the $950 you loan me today, to be able to buy the same groceries.

This means I need to charge more interest if there is inflation. And if there's more inflation, I need to charge still MORE interest.

In an inflation-free universe, I need to charge $10 interest -- I loan you $1000, you pay $1010.

In a low-inflation universe, I need to charge $60 interest -- I loan you $950, you pay $1010

In a high-inflation universe, I need to charge $110 interest -- I loan you $900, you pay $1010.

The more inflation there is, the less the eventual $1010 I get back is worth now, so the less I can loan you in today's dollars, and the higher the interest rate. It has nothing to do with internal vs external economy, and simply having to do with the value of money.

 

[Beerina]

Yes, but that has nothing to do with why the central bank raises rates. It does this to contract the money supply (less is borrowed = less floating around = less bought = less inflation).

And his point is that, in this case, the inflation is due to externalities (oil, directly and reflected in the cost of bananas). Hence they're doing nothing to stop that inflationary cause.

It will have a minor effect in that Australians buy less gas and oil because they're poorer now, which will percolate into lower demand for things, but that's a minor thing.

It will slow Australia's economy, which no doubt is already slowing due to oil costs. Oil-based inflation will not be affected noticeably.

I'm with the poster on this one, what are they thinking? Unless, of course, the inflation is due to more than just oil, something domestic policy could affect.

 

[Mycroft]

OTOH, in recent years when mortgage rates have been so low, it seems pretty silly to do an ARM considering that it was pretty clear they would be coming back up at some point. When you can lock in at 5%, why bother with the risk of an ARM to get 4%?

Well, the reason would be if the person didn't anticipate keeping the loan beyond the fixed rate on the adjusable rate mortgage.

 

[pgwenthold]

Well, the reason would be if the person didn't anticipate keeping the loan beyond the fixed rate on the adjusable rate mortgage.

And that's what it has to be. OTOH, when interest rates are hovering around 5% for a while, you better not be expecting to hold on to your ARM very low.

There are people who do that in the real estate speculation area, but for a home buyer, it's not a good approach.

 

[Bob Klase]

Well, the reason would be if the person didn't anticipate keeping the loan beyond the fixed rate on the adjusable rate mortgage.

There is a small minority of times where it makes sense to get an ARM rather than a fixed rate, just as it makes sense for a small percentage of people to lease a car rather than buy. I think the vast majority of the time people just use an ARM so they can buy more than they can afford, then complain when they have to pay for what they bought.

 

[a_unique_person]

There is a small minority of times where it makes sense to get an ARM rather than a fixed rate, just as it makes sense for a small percentage of people to lease a car rather than buy. I think the vast majority of the time people just use an ARM so they can buy more than they can afford, then complain when they have to pay for what they bought.

Adjustable rates is the standard way of doing it in Australia.

 

[Rob Lister]

Adjustable rates is the standard way of doing it in Australia.

Well, use your leverage as a consumer and get a fixed rate.

Unless it is somehow illegal, it should be available, even at an increased rate (a point or so over ARM).

Here, fixed rates are more the standard (but by no means exclusive...I'd give it a 70:30 ratio on a complete guess).

I'm not surprised your inflation is rising though. You've been doing very, very well macro-economically for a long time now. Are you sure it's just Gas and ...bannanas?

 

[Mycroft]

Adjustable rates is the standard way of doing it in Australia.

Yes, it boggles the mind that consumers don't even have the option to lock in rates. In the States even our adjustable rates have periods where the rate is fixed.

 

[Mycroft]

There is a small minority of times where it makes sense to get an ARM rather than a fixed rate, just as it makes sense for a small percentage of people to lease a car rather than buy. I think the vast majority of the time people just use an ARM so they can buy more than they can afford, then complain when they have to pay for what they bought.

As a mortgage broker, I’ve learned not to project my own values and needs onto my customers. They often choose the fixed rates, and I fully support that, but the ones that choose ARMS give me many reasons for doing so. The most popular reasons are either they only plan on keeping the home only for a few more years, or they believe they will be making more money when the loan becomes adjustable. As a professional, I advise each and every one of them what I think their best options are based on their needs and goals, but only about half of them take my advice.

 

[a_unique_person]

You can get fixed rates, all you have to do is ask. For some reason, variable is the way most people go. It's cheaper at the time you buy it.

 

[Mycroft]

You can get fixed rates, all you have to do is ask. For some reason, variable is the way most people go. It's cheaper at the time you buy it.

Really?

Then why don't more people lock into low fixed rates while they can? How about refinancing into a fixed rate?

 

[gtc]

Australia's mortgage market is quite different to the US system.

For one, we don't have the big semi-government Fannie Mac's and Mays. Since deregulation in the mid-80s most home loans have been adjustable. I don't really know enough about the Aussie mortgage industry to be able to comment more than that.

My understanding about interest rates is that the RBA is worried that food and oil price rises will trigger a general increase in business costs and then prices and wages and so on.

 

[a_unique_person]

How can they not pass on the costs?

 

[gtc]

Well, they can pass on the costs. However, the worry is that an inflationary spiral will start.

A raises its prices so A's customers (who work for B) demand higher wages from B, so B raises its prices. So then B's customers (who work for A) demand higher wages from A. So A raises its prices and so on.

An interest rate rise is supposed to interupt that cycle.

 

[a_unique_person]

What will happen is that those who can least afford it will heroically perform that function for the rest of us.

 

[gtc]

Well, do you have a better suggestion for controlling inflation?

 

[a_unique_person]

It's just funny that that's how it works. Those who can least afford it shoulder the burden.