I got a couple of questions after Wednesdays email which I really want to address. I think the questions (and the answers) go well beyond 5 Minute. So for those that only read this out of politeness, now is your cue to press delete. For the rest of you, strap in.
You talked about how 4.25bn dollars could be disappearing from peoples spending as a result of interest rates increasing. But it doesn’t right? It has to go somewhere? As in someone is going to receive that extra money? I assume it’s the Reserve Bank of Australia (RBA)?
Bob, great question. It’s something I used to wonder a lot about too actually. I was always like, “just because the RBA says that interest rates are changing, why does that mean that interest rates actually change”? True story. Well, it’s all because of this…
Four key things you have to know first:
- The RBA tries to manipulate the way we save and spend by changing the level of interest rates in the economy.
- One way of thinking about interest rates is as a proxy for the cost of money. When interest rates are low, money is cheaper. When they are high, money is more expensive.
- Prices go up (in general) when demand increases. Prices go down (in general) when demand decreases.
- Prices go down (in general) when supply increases. Prices go up (in general) when supply decreases.
So… with that, what does the RBA actually do when they say they are changing the official interest rate? They change the amount of demand and supply there is for money in the economy. You can read about how they do it here, but for the purposes of 5 Minute, this is what you should know.
This is a horribly simplified version of what actually takes place
As I said, to change the level of interest rates, the RBA changes the amount of demand and supply there is for money in the economy and they do this by changing the amount that they borrow and lend in the market. So if they decide in increase interest rates, (which effectively means the price of money is increasing), the RBA increases the total demand for money, by BUYING more money. What that actually means is that they are going to banks and borrowing money from them. And they will keep borrowing money until the market level of interest rates hits their desired “target” level for the official interest rate. If they want to decrease rates, they do the opposite.
But they don’t just do this on the day they decide to change interest rates. They are actively in the market EVERY SINGLE DAY adjusting the amount of demand and supply there is for money so that the overnight interest rate is almost exactly what they have targeted.
So to your actual question – the process of the RBA increasing and decreasing the amount of demand and supply there is for money effectively creates and destroys money. When the RBA eventually decides to increase rates, they will effectively destroy money, reducing its availability. And like I said on Wednesday, a 0.25% increase, will likely destroy about 4.25bn dollars.
Don’t the banks get a lot of their funding from overseas? So if interest rates go up in Australia, can’t banks just raise more money overseas where it’s cheaper?
FYI – this one is more complicated than question 1. You really don’t have to read it.
Thanks Henrietta, it’s a good point. However, if a bank raises money overseas, it does so in the currency of the country it raises money in. So, if say the Commonwealth Bank chooses to raise money in Europe, where interest rates are close to 0%, they will receive Euros from the lenders. Obviously this isn’t helpful for the bank, as all its deposits are in Australian Dollars. So, it will sell the Euros and buy Aussie dollars.
So the bank has sourced money in a market where interest rates are 0% and they can now go and lend this money in a market where rates are 1.5%. All good right? Not really. The problem is that at some point in the future, the bank is going to have to pay back the lenders the Euros it originally borrowed. So if you think about it, now the bank is carrying currency risk. What happens if Euros double in value relative to the Australian dollar between now and when the bank has to pay the debt back? #problem.
To get around this risk, a bank will enter into a contract whereby they essentially lock in the future exchange rate of the AUD vs EUR, so as to remove any currency risk. The cost of this contract? About 1.5%….
So essentially, the cost of hedging the foreign currency risk is approximately equal to the interest rate differences between markets. And because of this, the cost of raising money either in Australia or overseas is approximately the same.
Anyway, that’s not really 5 minutes. But for those that chose to read, hopefully it helped.