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Part 3: Government Spending, Inflation and Interest Rates

27th Jul 2021 | Ben Pauley


In our last blog, we spoke about what inflation is and how it might come about. Today, we thought we would discuss how banks around the world fight inflation and why they might do that.

Inflation: A fine balance.

There is a general acceptance, rightly or wrongly, that a level of inflation is good. It spurs spending and economic growth. If things remained the same price or if prices fell, people would defer expenditure for the future and you may see economic growth falter or fall. Modern day, I believe this is referred to as FOMO.

Inflation also, however, has its downside. If inflation is too high, people will rush to spend their money. If a dollar today is worth much less than a dollar tomorrow, why not spend it today? This, as we alluded to with QTMT, causes further inflation and can lead to continually increased prices and hyperinflation.

It is a fine balance and needs to be managed.

The Role of the Reserve Bank

The Reserve Bank is required to keep inflation at manageable levels with a target of 2%. If inflation runs hot (too high) or too cold (too low), the Reserve Bank takes steps to remedy that with the tools at their disposal. The most common of these is an adjustment in interest rates. When economic activity falls or there is deflation, the Reserve Bank lowers the OCR (official cash rate) and the inverse when things start heating up.

With interest rates low, people spend and bring consumption forward. Conversely, when rates are high spending slows.

The second tool common in RBNZ’s arsenal is an asset purchase program. Simply, this is money printing. The bank buys bonds from the government and banks with very low yields. This helps compress interest rates and injects further money into the economy (they ‘print’ money to buy the bonds). The increase in the money supply flows through to the public and they begin spending.

The Impact of COVID-19

About 15 months ago, the worlds economies shut down entirely. People were encouraged and instructed to remain at home. Factories shut. Restaurants closed. Zoom’s downloads went through the roof. Governments became worried about economic growth, forecasts were for imminent economic doom.

In New Zealand, the response was swift. We saw interest rates cut to record lows and an undertaking from the Reserve Bank to keep them like that indefinitely. They also announced a record asset purchase program, earmarking $100bn for asset purchases. The rest is history, see property boom, strong employment, expensive latte’s and steady economic growth.

What we are currently seeing with fixed rates out 3 – 5 years is the public forecasting that interest rates will be rising in the future. These rates have all increased significantly in the last month, 5 years at 2.99% is a thing of the past. ASB recently hiked their short term rates almost 0.40% which is an indicator of what is to come.

What’s Happening Now?

We are also now seeing the RBNZ peddling back from its stimulus programme, with recent reports suggesting they are going to leave close to $45bn on the table (out of an earmarked $100bn).

Rising interest rates and reducing Reserve Bank money printing should see things start to slow and a change in market sentiment and activity. Borrowing costs are climbing, the money supply is no longer rapidly increasing, incentive to hold cash will increase and activity in the market should slow down. This may all lead to a fall in asset prices and a corresponding fall in individuals’ perception of their personal wealth.

The goal is to take some of the heat out of the economy, slow inflation and ensure that things don’t become overheated. We may achieve that, we may not do enough, or we may also overshoot.

Until next time…

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