Why Interest Rates Are In The News

The Age

Monday June 27, 1994

DAVID McKENZIE

Interest rates have suddenly become as issue in their own right amid constant talk of ``tightening monetary policy", ``sell-offs" and cash rates. David McKenzie examines what it all means.

For months, we've been regaled with reports of what the accelerating economic recovery means for interest rates.

Now, just to complicate matters, interest rates have become an issue in their own right, as we hear of bond market ``sell-offs" and long- term bond rates being pushed through the roof.

The Federal Government, backed by many commentators, says there has been no change in economic fundamentals - especially inflation - to warrant such a development. It has accused the financial markets of being irrational and inexperienced.

Day after day, senior Government ministers have held the same line - there will be no increase in ``official" interest rates in the immediate future, although rates will have to rise at some stage during the recovery to keep the lid on inflation.

The governor of the Reserve Bank, Mr Bernie Fraser, has also warned home borrowers to ``factor in" the reality of higher future rates when making their decisions. He made it clear that the bank would act to keep inflation below three per cent.

So what does it mean? First, when people talk about a ``tightening in monetary policy", they are referring to short-term overnight cash rates.

These are what the Reserve Bank changes when it wants to send a signal that it is changing its stance on monetary policy. That's why these rates are usually referred to as ``official".

There are also other interest rates that are set in the marketplace - but which are influenced by what the Reserve Bank does at the ``short end" of the market because of the impact of competition.

Home lending rates - and the interest rates you can earn on deposits - are set by the banks. Banks also set rates on business overdrafts, personal loans and credit cards.

In the bond market you can buy a range of assets with differing maturity dates. Long-term ``bond rates" - alternatively known as market rates - usually refer to the interest rate on a 10-year bond.

A ``sell-off" in the bond market means that people are offloading their bonds, pushing the price down and increasing the interest rate, or ``yield", that these bonds offer.

For the Federal Government, interest rates are one important way of influencing the economy.

Higher rates can discourage spending by households and business through the higher cost of credit and the increased drain on incomes from higher debt repayments.

This is what took place in the late 1980s, when official interest rates were raised sharply - to about 18 per cent - in an attempt to cut spending and avoid a potential balance-of-payments crisis.

Now the economy has improved, talk of a possible rise in official rates reflects a view that faster growth will inevitably push up inflation.

With the Budget - or fiscal policy - now determined for 1994-95, interest rates are the only quick policy weapon the Government has to keep economic recovery under control. But it is wary about raising interest rates because business investment is subdued.

None the less, the financial markets have themselves pushed up long- term interest rates in advance of any official action.

Yesterday, rates almost hit 10per cent, a rise of three-and-a-half per cent up since February.

Financial investors are interested in the real return they can expect on their financial investment - that is, the rate of interest, or the yield, less the expected rate of inflation over the period of the investment. If they think inflation is likely to increase, they will want a higher rate of interest.

And this is exactly what they see looming over the next couple of years as economic recovery accelerates - even though, as Mr Willis correctly points out, there are no signs of that happening yet, and most observers expect inflation, now around two per cent, will stay below four per cent for some time.

But this cannot explain the big jump in market rates. Rather, the most important influence is the fact that our financial markets are part of the international scene.

When interest rates and inflationary expectations in the United States started rising earlier this year, so too did market rates here.

Most observers expect official rates to increase here at some stage - a move that would also see higher housing and business rates.

A problem for the Government and the Reserve Bank is that they don't want to be forced by financial markets into raising rates, especially when rises have little to do with Australian conditions.

Such a move, without any sign of a change in these conditions, could seriously undermine the credibility of monetary authorities.

But the longer bond rates stay high and the markets remain volatile, the bigger the danger that businesses and households will grow nervous and curtail their spending decisions.

The Government has signalled that it will act sooner rather than later to contain inflation, saying this would minimise the extent of interest rate increases.

Most observers expect a move on official rates within the next couple of months. The most likely timing is early August.

But even the most pessimistic forecasters expect interest rates to be, at most, only three per cent higher by late next year. We are not likely to see a repeat of the late 1980s.

© 1994 The Age

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