“I know the RBA sets interest rates but I’m embarrassed to ask why.”

Someone said this to me at a party recently. In trying to explain interest rate policy by shouting over Daft Punk I achieved simultaneous pedagogical and social failure.

This setting, I hope, is a more appropriate place to provide the answer.

The Really Simple Version:

Interest rates are the brakes on inflation (price rises). When the RBA changes interest rates, they are trying to control inflation.

Higher interest rates slow inflation down.

If you notice the price of a sandwich keeps going up, the Reserve Bank is probably getting worried about high inflation. The RBA watches price rises by looking at the consumer price inflation data. If inflation is getting too high they will raise interest rates.

Lower interest rates speed inflation up.

On the other hand, if shops are having big sales that suggests prices are falling. The RBA is probably worried about low inflation. It might cut interest rates.

The RBA’s job is to keep consumer price inflation between 2 per cent and 3 per cent, annually. If price rises are above 3 per cent, they will raise interest rates. If price rises are below 2 per cent they will cut interest rates.

How does that work?

High interest rates slow down spending.

For people: If interest rates go up, it makes sense to put more money in the bank, not spend it.

For companies: If interest rates go up, you won’t borrow money to build a new factory. You’ll try to pay back your loans.

Low interest rates do the opposite.

For people: If interest rates go down, it makes sense to take your deposits out of the bank and spend them.

For companies: If interest rates go down, you can borrow to build a new factory.

Spending matters because the rate of spending affects the way companies set prices. If items are not selling, companies will put them on discount. If they are selling out, they may even put up prices.

This is the basic lesson. The RBA is controlling interest rates, to affect spending, to affect inflation.

The fairly simple reason we care about inflation:

Too much inflation can be bad – it means the money you have saved buys less and less.

But we don’t aim for no more price rises ever – because price rises can be good. Inflation can be good because it CAUSES spending. I know we just said spending causes inflation. But it works both ways. Think about this:

If inflation is high, your money is losing value, so it makes sense to spend it. If $100,000 will buy you a Mercedes today, but it will cost $105,000 next year, it makes sense to spend the money now. That spending will pump up the economy.

If inflation is low, however, it makes more sense to save your money. Of course, if everyone saves, the economy suffers.

i.e. The way people react to inflation (spending/saving) is important to economic growth.

The RBA tries to balance the speed of the economy so we get the right amount of spending and saving to keep the economy growing. Inflation is kept between 2 and 3 per cent, because we’ve decided that is a good range to keep spending and saving in balance.

Why do we care about growth? Growth affects unemployment, and thereby people’s health and happiness. That’s why the newspapers pay so much attention to it.

Advanced class: How does the RBA control interest rates?

The RBA doesn’t set your bank account interest. And it doesn’t set your home loan rate. So what is it controlling?

The one market that rules them all.

The overnight cash market is the shortest-term loan in the market. Big banks borrow in there for just a few hours.

Because you can make a year-long loan out of 365 overnight loans, targeting the overnight loan market affects all other loan markets.

So the RBA gets in there and plays. It literally buys and sells money in that market so that the interest rate does not deviate from the publicly announced official cash rate (at present 2.5 per cent).

(Interest rates are the price of a loan, so increasing supply of money in that market lowers interest rates, decreasing supply raises interest rates).

The RBA is damn good at getting the overnight cash rate to match the target rate.

PhD level: Does the RBA have to balance unemployment against interest rates?

In the United States, their Reserve Bank (the Fed) has what they call a dual mandate:

“maximum employment, stable prices”

In Australia, the RBA technically has a triple mandate.

The Reserve Bank Act 1959 says it must act to ensure:

the stability of the currency of Australia; the maintenance of full employment in Australia; and the economic prosperity and welfare of the people of Australia.

But that has basically been waived. A statement is agreed between the Treasurer and the Governor of the RBA after each election, agreeing that the bank should focus most on inflation when setting monetary policy:

“…allow the Reserve Bank Board to focus on price (currency) stability, which is a crucial precondition for long-term economic growth and employment, while taking account of the implications of monetary policy for activity and levels of employment in the short term.”

Why not focus on employment too?

Back in the day, economists thought you could have low unemployment if you were willing to pump up the economy enough to have high inflation. Now we know this is not true.

You get a short term bump in employment under high inflation because the wages are not actually worth as much as the workers thought they would be. Workers aren’t dumb though, so once they re-calibrate their inflation expectations, they stop being willing to work for those crappy wages.

That means solely focusing on inflation is the surest way to promote low unemployment.

That’s the end of the lesson on interest rates! I hope it was helpful. Now you can nod wisely when Alan Kohler does the finance news.