Uncensored Money Season Three: The Link Between Interest Rates & Inflation Rates 

Melissa Browne: Ex-Accountant, Ex-Financial Advisor, Ex-Working Till I Drop, Now Serial Entrepreneur & Author, Financial Wellness Advocate, Living a Life by Design | 29/06/2022


Show Notes

There has been a lot of talk in the news recently about inflation rates, lifestyle creep, interest rates and the cost of living. So over the next few episodes, Mel and Lawsie will unpack these topics and share practical tips you can implement straight away. 

In this episode, Mel and Lawsie discuss the link between interest rates, inflation rates and their impact on the cost of living. 

If you know you need more help with your finances make sure you join the waitlist for the next round of the My Financial Adulting Plan

If you're not already, come play over at insta at More Money for Shoes and make sure you are signed up to Mel's Money Musings and Monday Money Moments (yep, we love us some alliteration) for more tips, tricks and ideas on how to best work with your money.

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Mel: Today, Lawsie and I are going talk all things, interest rates inflation rates and cost of living. We're gonna do it with our just finished COVID sexy croaky voices. So bear with us

Lawsie: So sexy.

Mel: But the reason I wanna talk about this is it's because I've received a lot of questions around what's the link between in interest rates and inflation rates, and what's the link between interest rates and the share market crashing.
Mel: And we wanna unpack that. Now we are gonna keep it jargon free, but we are also gonna get a little bit technical. And this is gonna mean, firstly, that you are gonna sound super smart at your next work drinks, but also so that you can make up your own mind when you see click bait headlines from the media.

Now Lawsie's gonna lead the Q& A with me so it's not just me banging on about it. And then she's gonna add her 2 cents as well as we. But let's start with why we are talking interest rates and inflation, and that's because the Reserve Bank Governor Phillip Lowe spoke to the American Chamber of Commerce in Australia at a function in Sydney this week. And he said higher interest rates were necessary to slow spending across the economy that was adding to the nation's inflation pressures. Now, this is not the first time that he's talked about inflation rates and interest. And certainly we are not the first country to talk about inflation rates and interest, but it was probably the clearest message to date where he's come out and really put that parallel. And it did lead to a flurry of media articles and DMs to me, just say what I don't understand.

Lawsie: Is this part of like your audition to want to be the Reserve Bank Governor? You can be like, it won't be Philip Lowe. It will be Melissa Browne.

Mel: I would not have that job for anything.

Lawsie: Oh, hell no. Hell no. Just wanted to check though, just in case

Mel: No, no, I love that. Yeah. Yeah. I'm always auditioning Lawsie. So I guess the first question I'll pose it is what are the inflationary pressures we're currently facing? And I think that's really clear. So they're global pressures that we are facing but in Australia and I'll talk to that specifically. Inflation rates if we look at the last, say, 20 years, 30 years, it's been sitting it historically at an average of about two and a quarter percent. Currently, we're looking at the last quarter of about 5% inflation rates and it's predicted that it's gonna be at 6 to 7% before the end of the year. And you might say, okay, well, I don't understand the problem with inflation.

The problem is if wage pressures don't keep up, if wages don't keep up with inflation, then it becomes more and more expensive for us to simply live. And if we look at 10 years, you know, if inflation's sitting about two and a quarter percent in 10 years time, it means that the cost of living's gone up by about 20%.
It's not so bad, but if it's sitting at 7%, then cost of living's gone up by 70%. Wages historically just haven't gone up by that much. And it means then that we are going further and further behind as far as how much it costs us to live.

Lawsie: Yeah. And therefore how many dollars you've got left to do anything

Mel: Exactly right. So that's what's called inflationary pressures and that's what the Government and the Reserve Bank is wanting to do something about. They wanna get that under control.

Lawsie: Yeah. And so what do interest rates have to do with inflation? Governor Melissa Browne?

Mel: Uh, in my current audition for it. So it might seem really strange to think, well, what do interest rates have to do with inflation? And I think if we take a step back, even, you know, if we look even at December last year, the Government were telling us to spend, our retailers were telling us to spend.

So people are now looking and going you told us to spend! And now you're saying that you're gonna put up interest rates to stop us spending. What the hell. It just sounds really strange, but the problem is in an era of really historically low interest rates, which is what we've had, it's meant that most of us have had more dollars to spend.
And particularly when, especially in the last two years in Australia, we haven't been able to travel. We haven't also had these added costs of even travel to work. Then suddenly we've got a lot more money to spend. And there were statistics that went round that it was quite literally billions of dollars that we were sitting on of extra dollars.
And we saw this with the construction boom. We saw this with renovation where people started to spend more and more on cocooning and on themselves. And what's that's meant is that there's this demand suddenly for construction. What happens is the cost of construction goes up, cause builders can go, huh? Hey, I can charge more cause everyone suddenly wants the services. So the link between interest rates and inflation is this battle that is being waged by the Reserve Bank Australia to keep the cost of goods and services at a level that people can afford. But also to make sure there's this balance of supply and demand. Cause if interest rates go up too much, then suddenly there's not enough leftover in our pockets once we've spent on housing to actually live and to spend. But if interest rates are too low, we might have too much money to spend. And suddenly that's what's forcing prices up.

So interest rates is a lever, if you like. So it's a way to control through the official cash rate what the banks set. So the basis points that the banks then set upon which we can borrow and the aim of the RBA, so the aim of the Reserve Bank is to keep inflation around the 2 to 3% range, if possible.
So if we are sitting in the land of 5%, if we're looking to 7%, that's why the government, the Reserve Bank is looking to, to put that up. So long answer

Lawsie: It is not exactly the easiest

Mel: It's not the easy thing, but essentially if we think of it this way, if borrowings are more expensive, people are more reluctant to spend reducing demand and putting pressure on sellers to make your pricing more competitive.

Um, so if there's fewer price hikes, then therefore there's lower inflation. So when the economy overheats. So that's that talk of it being out of control and that inflationary pressures, that's where demand outstrips supply, and where inflation just goes through the roof, which is what we're in now. So increasing interest rates hopefully helps reduce that demand.

Lawsie: Very nicely explained Governor. And so I know you said the target rate that the RBA is looking at is obviously that two, two and a half percent, which is generally where it sits. So, and then obviously that's feeding into why there's still all this talk that there will be more interest rate rises this year, because if we are predicting, you know, inflation to be sitting at 7%, well, let's pull on that lever. Let's bring up the interest rates and then hopefully bring back down.

Mel: And if you are interested at what the CPI is running at, that's released every month. So that's a monthly figure that it's released. So if you are wanting to have a look at whether we think there'll be interest rate rises, take a look at what those figures are that are released, and that will give you a good indication as to whether is inflation dropping back down to more like that 2%, 3%, or is it continue to gallop?

My prediction is I think that we're looking at probably another at least a 1% increase this year. I heard an economist the other day say that the Reserve Bank really needs to make it, you know, 1.25 next month. I just can't see that happening. That's something that will scare people. I think that will see probably another 0.5 next month and then 0.25, then 0.25. That's the Melstar's prediction.

Lawsie: Ooh, I like it. And I think to your point too, is this: it isn't just something that's happening in Australia. Like if you cast your eyes over to the US, you'll see that they've already, they're facing similar pressures. They've already put up their interest rates and by significant amounts.

Mel: Oh, far more than us. New Zealand is the same UK. Yep.

Lawsie: Yeah.

Lawsie: Yeah, exactly. Right. So it shouldn't come as a surprise to anyone. But at least just understanding around the reasons as to why it happens and all

Mel: And you going and choosing not to spend as much isn't gonna reflect affect that. So if you go, oh, well maybe if I stop spending for six months, the interest rates won't go up. That's kind of not really how it works, but we'll naturally spend less or will naturally be more cautious. And as that happens, when you'll probably already notice that you're starting to be really conscious at the groceries or conscious at the fuel, or, instead of getting your haircut every six weeks, you might make it every eight weeks. You'll naturally be doing that anyway.

Lawsie: Yeah. And I don't think there's anyone that we've spoken to, certainly that I've spoken to recently that hasn't had a comment to say about my God cost of living is going up. And it is that real, you know, people will go through ebbs and flows with it, obviously, depending on their own personal situation. But it's just this across the board thing. It's like, wow, I actually have to make changes to what I'm doing to make sure that I can still be achieving the other goals that I'm working towards or make adjustments to the goals that I had, cause I just can't get my dollars to stretch enough.

Mel: But if I describe it as a really simple, you know, if I, if there was a kid's fate and I, and if all the kids had stalls.

Lawsie: Do I get like one of those toffee things?

Mel: There was toffee apples. I would want toffee apples, chocolate crackles. So the kids are all selling stuff. And if, you know, if the kids are all reluctant to spend, then what the parents might do is say here's a dollar everyone.
And that would be what we all just did with the stimulus payments. Here's some money go and spend. So the kids run out and they suddenly get used to spending. And then when they receive their pocket money, next week, they've kind of got used to spending. So therefore they spend again at the fate.

So it's kind of greased the wheels of spending if you like, but there will come a point where, because all the kids want chocolate crackles and the toffee apples, the people in those stores can go, oh, I'm running out. I'll just start putting up prices and the prices of toffee apples and chocolate crackles then double.

But the kids still want it. So what the adults could do then would be that we're now gonna tax your pocket money. So instead of giving you a dollar, we're gonna give you 50 cents or 70 cents. So suddenly there's less money there for the kids to spend. So therefore, yes, they all still might want chocolate crackles and toffee apples, but they simply can't afford as many anymore, which means the toffee apple and the chocolate crackle sellers have a choice. Either they sell less or they stop rising prices or they even drop prices. So that's essentially what the bank are doing with interest rates and that demand.

Lawsie: Sure you don't wanna be the Governor? I like this. Imagine you fronting the news <laugh> And I guess, I mean, the other thing that we are seeing as well and hearing, particularly the last couple of weeks is this whole concept of the bear market and why, and I guess if you can explain too, how that ties into the interest rates and inflation as well. Cause I think that's another thing that's kind of all linked.

Mel: Yeah, I agree. So when we say bear markets, so there are different types of cycles in a… Lawsie's pretending to be a bear <laugh>

Lawsie: I'm very scary <laugh>

Mel: So a bear market simply means it's a market where for the prices have been going down for two months or more, prices have dropped by 20% or more. A bull market is the reverse where prices have been going up for 20% or more. Markets are cyclical. You know, we don't hear of property markets being called bull or bear markets because we simply can't buy and sell them in the same way that we can buy and sell shares. That there's not that liquidity there. But because it's there with the share market, that's why we have these cycles where it can really swing and swing quite wildly, which is really what we're seeing at the moment. So we started off seeing it in the tech sector where we saw the tech crash happen from as far back as January, this year. And now we're seeing it across essentially the whole of the market, where the markets across the board have dropped by more than 20%. So it's called a bear market. And if you picture a bear falling down, that's why they call it a bear market, as opposed to a bull rearing its head, um, and spiking the poor, not poor man cause he stupidly puts himself in the ring.

Mel: Um, the poor man with the wavy thing.

Lawsie: rag

Mel: Thank you.

Lawsie: the flag. As much as this is a podcast and everyone gets to listen to it. But if they could see our beautiful rendition of going up like a bull and then falling down like a bear or just top it off.

Mel: Our play school actions are great.

Lawsie: Oh yeah. Mm-hmm

Mel: But a market is skittish. So a market, um, think of it like a conservative middle aged white man. So they just want it to be calm, little bit of peaceful, they don't wanna see highs and lows. They don't wanna see swings going on with currency or with inflation.

They just wanna see calm seas. So when they don't see that, that can make the market skittish, which can mean that it reacts to either bull or bear. But certainly if we looked at bear markets, in a time of higher inflation, that's where prices can go up. So therefore, with rising interest rates, essentially what the Reserve Banks' equivalents around the world are trying to do is to try to stop people's spending. And what we know is the stock market is full of companies that are all selling goods and services. And if the governments of the world and the Reserve Bank equivalents of the world are trying to stop people spending, then that's gonna affect those companies that are in the stock market. Meaning essentially their profits are gonna be reduced. So they, therefore they're not gonna potentially seen as an attractive proposition as they might have been in a period of low interest rates where people are spending.

So that can be why during a period of reduced spending and higher interest rates, that might be where that demand for shares is slower as the company show weaker revenues. When the reverse is true, when there are lower interest rates and increased spending, then the demand for shares can grow because they're gonna have strong revenues and strong profits.
Therefore they're seen as more attractive to investing. So the share market was described really beautifully by Vanguard in our masterclass last night as like an eBay marketplace, when there's a whole stack of buyers and sellers. And we forget that. So we forget that the market is made up of all these companies of people wanting to buy and sell a piece of these companies.
And if those companies, if we look at what's happening in the market, and if we don't believe they're gonna be performing as well in the conditions that we're currently facing, that's where they're seen. That's where people are withdrawing their money and withdrawing their investment in those companies.

Now, smart players know that the market, that bull markets and bear markets are cyclical, and they aren't withdrawing their money and they're riding it out. But what we know is that people react with emotion and they're pulling potentially pulling that market out, seeing this happen and thinking that's what's gonna happen.

Inflations generally tended to affect growth stocks more than value stocks. So that's not gonna say that all of the shares in the stock market are gonna be affected the same. There are definitely still some stocks that are going to perform well during a bear market. The trick of course is picking them, which is why most people are better off with an index fund or an ETF, cause they don't understand the difference between a gross stock or a value stock.

Mel: They don't understand what sort of shares. Or they don't even understand the cycle of a bull and a bear market. And let's be honest, experts don't even understand that, which is why if you are investing and if you're looking at the current bull market and going, oh, should I be withdrawing my money? Is now a bad time to invest? Actually think quite the opposite. You know, if you are dollar-cost averaging, if you are investing regularly, yes, you are going to buy when it's at its peak which it potentially was back in December, but you are also gonna buy when its prices have dropped and they're low, which is what's happening now.

So I want you to reframe that. To think, well, actually it's on sale at the moment. So to keep going with that beautiful long-term goal that you have with your investments, to make sure you have diversification, but to have that discipline of just continuing to invest regularly and almost to ignore what's happening with the market, as long as you are diversified, as long as it does still match that beautiful long term goals. But that's potentially why we are seeing a drop in the share market and why it's tied into interest rates and inflation.

Lawsie: Beautiful. And I think one of the other things just as a different way for people to think about it too is to be socially distant from their investments. Cause that just ties into that whole thing where you are going remove the emotion from it. Yes. Everyone's looking going, every time you log into your brokerage account, you're going, oh great, everything's dropped. And the longer you see that the more stressed and emotionally involved that you can become with that. And therefore be more tempted to sell and not to follow those kind of….

Mel: Or not to continue to…

Lawsie: invest. Yeah. So I think just your comment that you'd made earlier on the social setting, around just being socially distant from your investments. So you can't be tempted to sway from all those great rules and processes and systems that you put in place with your investing

Mel: Don't look at it. Yeah, absolutely.

Mel: Mm-hmm

Lawsie: So you might need your crystal ball for my next question. But how high do you think we can expect rates to go?

Mel: So well, personally, I think this year we're gonna be looking at least 1% more. I think in 2023 for the first half the Reserve Bank will watch and see just to see what effect that has. If it doesn't slow inflation, I think we'll see more so potentially even another 1%

I think we are looking at more like 3 to 4% as opposed to the one, the one and a half that we are currently looking at now. So it might take a while to get there. But if we look back even three, four years ago, we were sitting at interest rates of between five and seven. That's more normal, you know, two to 2.5% is not normal.

So you'll hear these things called basis points. So people talking about 25 basis points, 75 basis points. That simply means percentage points. So when I say at 0.25%, someone else might say 25 basis points, it's exactly the same.
But what we've talked about for a long time is to act as if those rates have already gone up. So we've said for years to always pay your loan as if interest rates were 1 to 3% more, cause one, it's gonna build a buffer, but also if interest rates go up, you are not going to be stressed. So that can be a great thing that you start to do anyway.

Lawsie: Yeah. And then next crystal ball question. How far do you expect markets to go down? To keep falling.

Mel: No one knows. And this is the thing. If someone tries to tell you, like we can have a bit of a prediction with interest rates with far better accuracy than we ever will with markets. And will they have further to go? Potentially because inflation rates are continuing to go up. As we see inflation start to be halted, I think we'll expect to see markets stabilize, but even with the Reserve Bank taking action, sometimes that can be enough to stabilize markets because they can see that that's happening. They can see that's coming. But anyone that tells you that they can time the market or they can predict the market is lying. Yes, there are some incredibly savvy people that have been able to in some ways, but most people cannot, even the best cannot. So how far can we expect markets to crash? Who knows? Am I continuing to invest? Absolutely. Cause it forms part of that beautiful long-term goal that I have. So it might be that I'm investing less in tech and more across the market, but certainly I am continuing to invest

Lawsie: Yeah, me too. Me too.

Lawsie: So any last thoughts or ideas for anyone, how they can be prepared for continued interest rate hikes, inflation to continue to go up, falling markets, anything like that?

Mel: I think it it's going back to the basics. I think too many people when COVID happened were like, oh, we should get into crypto. Oh, I should just start investing in shares immediately. So they've kind of gone to the trick shots, but without learning how to kick and pass. So I think how you learn the basics is what are your goals? What's your financial story? What’s your money story? What's your money type? Uh, what are my short-term goals? What are my long-term goals? What am I spending like and what incomes coming in? You know, how much do I have left at the end of the day? What do I want in the next three years?
And what does that look like for the next 12 months? But then also, if I have debt getting rid of that. Making sure that I have a buffer account of three to six months worth of expenses. If I have a mortgage paying it at one to 3% more. If I have bad debt, choosing to get rid of it. So it's doing all of those things well, rather than trying to do tricky things. And that's how we prepare is by increasing our financial literacy, increasing our financial confidence and having that beautiful financial base. And if you are listening to me going, oh God, I know I should do that and I still haven't, then join the waitlist for the next round of the My Financial Adulting Plan in September, because over eight weeks we teach you all of that. We teach you how to prepare for uncertain times as well as how to prepare for times that are good, because really it's the same.

Lawsie: Yeah, keep doing the basics well, and consistently.

Mel: Exactly. It's not rocket science. And I think too many people are looking for the silver bullet, but actually it's learning how to do the simple things. Well, and then layering it as you become more and more confident

Lawsie: Beautifully said, Governor. Thank you.

Mel: Therein ends my submission

Lawsie: You are now appointed by me

Mel: Hell no. Anything you would add to that Lawsie.

Lawsie: No, I think that's, it is exactly that. I know in conversations that've been having with people, people are starting to get a little bit on edge. It's kind of really if they're relatively new to investing, it's the first time that they're physically experiencing a bear market that they're seeing things drop as well as you know, like I said before, people are really starting to feel the pinch with the grocery store and the fuel and all those things. So I think that's just, it is a perfect reminder around, yes. You might have to adjust how much you've been investing if you can't get your dollars to spread enough. It's not to say that you won't necessarily have to make tweaks and changes, but I think it's just being aware that that too is actually okay. And then just following the basics and just not getting scared and, you know, being tempted to go, oh, I'm just gonna convert everything to cash out. I'm just gonna do this because that's when you are gonna go backwards. So it's just about socially distancing from your investments if you need to. Continuing to follow your investment strategy, and if you're not up to investing, then covering off those basics like we said, in terms of getting rid of your bad debt, working out what your goals are, and then putting in a plan to keep doing those, regardless of everything else that's happening around you.

Because unless you're the Governor, you're really not going to be in direct control of what can actually happen. So it's just about being in control with what you can do and just having trust and faith I guess that if you are doing the basics and continuing to follow all the systems and processes that you've got in place, that you'll be fine. It might just, it might take longer. It might be a few months of weathering this, it might even go into next year, who knows. But just if you're making sure that you're doing those things, then you're doing all the right

Mel: Yeah, I love that controlling what you can and ignore and, and sort of ignoring the rest. Yeah.

Lawsie: Yeah.

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