Saturday, June 14, 2008

Reserve Bank Policy Madness

I'm not the sheep type. I always believe in asking questions. After the umpteenth increase in the bank rate, I finally have had enough, so I went to the Reserve Bank web site and clicked on the "Contact Us" button to ask the following question:
I understand that inflation occurs when prices are raised, such as electricity, fuel, food, wages, bank charges, etc.
I don't understand why inflation is supposed to be reduced by raising the bank rates, in particular home loans. If the cost of my home loan goes up, how is this different from the cost of fuel or electricity going up?
Please advise
I will post the SARB response. If anyone would like to explain this anomaly in non-jargon terms, please feel free to leave a comment.
Update: "Patrick" from the reserve bank sent me some "Fact Sheet" PDF files, that you can find at the reserve bank's web site by going to the "About Us" section and clicking on "Fact Sheets". I guess if they need to explain it in 8 fact sheets then the simple answer is that there is no simple answer and we must just shut up and pay. Thanks for nothing.

8 comments:

Anonymous said...

Hi,

By increasing the interest rates, the reserve bank is reducing the amount of credit readily available to the consumer. The consumer thus has less money to buy the relevant articles in the inflation basket.

It follows that there is thus less demand for goods and services. By reducing demand, the price of goods do not need to increase as much, in accordance with the supply and demand curve. This would thus be effective in a demand-pull inflation situation.

This also links to the money-supply theory that stipulates:

MV = PQ

• M is the total currency in the nation’s money supply
• V is the number of times per year each currency unit is spent
• P is the average price of all the goods and services sold during the year
• Q is the quantity of goods and services sold during the year

and thus by reducing the total money supply, ceteris paribus, the increase in prices can be reduced.

In my opinion though, the current inflationary outlook is more of a cost-push inflationary type, and could not be directly counteracted by an interest rate increase. I believe it reflects the increase of the built-in inflation rate, and the accompanying adaptive expectations of the South African public.

Unfortunately, it seems uncle Tito is more of a Monetarist, and only time will tell whether this will result in a recession.

Donn Edwards said...

Thanks for the explanation, but how does raising the cost of my home loan reduce the amount of credit available in the economy. It certainly doesn't give me any more or less credit, in fact it is pushing me to borrow more and save less.

Anonymous said...

True, your home loan suddenly isn't as cheap anymore, but extending credit suddenly becomes more onerous.

New credit is thus not available to those who would desire it. Unfortunately, banks are less reluctant refuse credit to those such as yourself, who regularly service their debts. Unfortunately, those who are not quite as fortunate get their homes repossessed.

On a one-on-one basis, raising the interest rates certainly doesn't do much. But what the Reserve Bank seems to be hoping, is that on a nationwide aggregate, people will borrow less since it costs more.

Somehow, I don't think the Reserve Nank quite gets the psyche of the average South African consumer.

But, as they reason, it worked in the past, why should it not work now.

Economics is still pretty much a theory, but the Reserve Bank seems to be banking (pardon the pun) that some of them may have a ring of truth.

Donn Edwards said...

I get it now. They want to put me in a position where I am over-indebted to the banks so they won't lend me any more money.

They do this by making my home unaffordable. The banks don't complain because they get all the extra interest from my home loan and from me maxing out my credit card.

The reserv bank can do this but the politicians would not get away with raising taxes by the same percent. It's just another way to screw the public and get away with it.

Anonymous said...

Yep,

Couldn't have said it better myself.

Anonymous said...

Just quickly... :)

Interest Rate rises are a mechanism to slow the economy down. How they do this is reduce the level of investment in the economy by making borrowing money expensive. But on the other hand it makes saving much more attractive. By reducing the amount of spending it reduces the demand fo goods. This is done as now consumers have a reason to save (higher interest rates hopefully the banks in ZA pass that on)and also a reason not to spend (credit is expensive). Thats very basic, basic explanation.

Donn Edwards said...

The reason why I can't save is that my bond rate keeps going up.

I understand that raising interest rates on CREDIT has the effect you are describing, but how does this affect my home loan, which isn't credit but investment. Or did I miss something?

It seems to me that raising my bond rate is an effective way of making SAVINGS more expensive.

Anonymous said...

Donn, its a two pronged process. Yes it does make your home loan more expensive. But that is the desired effect. If it becomes harder for you to pay the more inclination you will have to spend less on discretionary goods (goods that you don't need but want :)). By doing this the Reserve Bank seeks to slow the economy down by limiting the amount of spending and hence investment. If you have a read of the multiplier effect it will shed more light on how powerful spending is as a whole and why controlling it can control the economy (most of the time).


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