Despite the headlines, money is still free

by Michael Pascoe

You might have noticed the occasional headline about interest rates soaring, the Reserve Bank threatening to smash the economy, and the end of civilisation as we know it.

The reality is that, while civilisation might be under threat from other issues, money is still free and is likely to remain free.

What? Free money?

Yes – money is free for most people in “real” terms, that is, after accounting for inflation.

What inflation does is reduce the value of money. In broad terms, the $100 that bought $100 worth of stuff a year ago only buys $94 worth of stuff today, if inflation has been 6 per cent over the past year.

In a very simplified form, if you borrowed $100 at 5 per cent a year ago to buy $100 worth of stuff, you’d have the stuff and the $105 you have to pay back today is actually worth a little less than $100 in terms of what it can buy.

The cost of borrowing the money – the $5 interest charge – is “free”.

That is an extremely simplified example. Despite the word “real” being used to denote “after accounting for inflation”, people perceive life in the “notional” rather than the “real” world.

And in the “notional” world, rising interest rates and the cost of the mortgage going up, is scary. The Reserve Bank wants it to be scary.

The RBA’s anti-inflation weapon of making money more expensive works in two ways: it reduces the amount of money people have left to spend after paying their mortgage, thus cooling demand; and it has the psychological effect of frightening people into not spending due to all the scary headlines and fear of how much higher interest rates might go.

Central bankers would prefer the psychological path rather than actually impoverishing people. If wearing a devil mask and jumping out of the bushes shouting “Boo!” helped soften demand, Governor Phillip Lowe might well do it – but that’s not the way it works.

Thus most of the pain of lifting interest rates falls on the minority of people who have hefty mortgages and the rest of us are free riding on their suffering.

You are right to think that is not fair or terribly efficient, particularly when most of the inflation we are experiencing will not be influenced by indebted Australians being poorer.

Taking more money out of the pockets of people with mortgages won’t stop floods pushing up food prices, Vladimir Putin (and soaring oil company profits) pushing up petrol prices, and supply chain problems pushing up construction material prices because of second-rate government policy that overheated the housing industry two years ago.

But as long as governments leave most of the inflation fighting job to the central bank (at arm’s length, “don’t blame us”), that is the way it works.

If people and businesses can push beyond the psychological impact of rising rates, they should be able to see that “free” money remains an opportunity for them if they are using it to invest in something that grows in value.

For the past couple of years, money hasn’t just been free for big businesses, they have effectively been paid to grab it.

This RBA graph doesn’t include the August rate rise, but you can see how extremely cheap money has been for big business and not expensive for small business either.

Source: RBA (click to enlarge).

Trying to guess how high the RBA cash rate will go is filling hectares of newsprint. My bet is that about 2.5 per cent by the end of the year could do it, so an extra 65 points on top of the present 1.85 per cent.

Add 65 points to those business rates – or most home mortgage rates – and money is still free if inflation is six to seven per cent, especially as interest costs are tax deductions for business and investors.

The RBA has copped plenty of stick – with all the benefit of hindsight – for maybe taking rates too low and leaving them down too long.

Hopefully the Martin Place mandarins have thick enough skins not to be provoked into now push them up too high too quickly.

There are signs the main causes of our present inflation are already starting to work their way out of the system. The biggest threat for our economic well being now is that the RBA increases rates too much.