Thursday, November 20, 2008

Tight, easy and neutral

Monetary policy is a tool by which government (usually through an independent central bank) can influence the economy by affecting interest rates.

To stimulate the economy when things are slow a central bank, like the Reserve Bank of Australia or the Federal Reserve in the US, will typically reduce interest rates to encourage people and businesses to borrow. To constrain the economy, they do the opposite and rates are increased. This makes the cost of loans more expensive and discourages people from borrowing. When things are going OK they neither raise nor lower rates.

When banks are raising rates they are said to be employing tighter monetary policy. When they are lowering rates they are easing monetary policy. When they leave rates alone monetary policy is said to be neutral. This is very general and other factors in an economic cycle can influence whether monetary policy is tight, easy, or neutral.

At present Australia, like almost all other world economies, is experiencing significant economic downturn. Despite the optimism that we may avoid a recession, the Reserve Bank (RBA) is still very concerned about the effect interest rates are having on economic activity and therefore are in the process of easing monetary policy.
Australian home-owners with a variable rate mortgage can look forward to an RBA cash rate around 3.50 per cent by March or April next year. For your mortgage this means a rate of about 5.10 to 5.60 per cent

The RBA states in its minutes that the reason for lowering rates by three-quarters of one per cent last month was that "given the changing balance of risks, there was an advantage in moving the setting of monetary policy quickly to a neutral position".

This means that despite the large interest rate cuts we have experienced recently, the RBA considers official interest rates may only be back to a "neutral" setting. Given that we are on the brink of a recession, this statement highlights how much further the RBA will cut so that rate are "easy" and therefore begin to stimulate the economy.

This means that Australian home-owners with a variable rate mortgage can look forward to an RBA cash rate around 3.50 per cent by March or April next year. For your mortgage this means a rate of about 5.10 to 5.60 per cent

3 comments:

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Trevor @ Financial Nut said...

I have recently been reading about how the Fed controls interests rates and how that relates to the economy. Thanks for the reminder!