Inflation can affect home loan rates because the Reserve Bank of Australia uses the cash rate to set the borrowing costs paid by banks and building societies to lend money to each other.
If the RBA increases or reduces the cash rate to match Australia’s inflation rate, it is likely to impact your home loan interest rate – even if you’ve owned your property for several years.
The key thing to remember about inflation is that it doesn’t just apply to prices; it also applies to wages and salaries. This means that if inflation rises, mortgage payments could increase too.
Correlation between inflation, interest rates and real economic activity?
Economics textbooks typically explain that there is a key distinction between anticipated inflation (inflations that were expected beforehand) and unplanned inflation. When inflation is anticipated, it allows us to take into account changes in prices ahead of time. We know how much we want to spend today, and we plan our spending accordingly. If inflation goes up, we adjust our plans accordingly.
In contrast, when inflation is unanticipated, we don’t anticipate an increase in prices. What happens next depends on whether the government takes action to reduce prices or not.
If the government doesn’t intervene, then the supply of money increases and the demand for money decreases. This causes the price of money to rise. Because people now pay more for money, they no longer want as many units of money as they did before. They decide to hold onto fewer dollars rather than buy more.
This reduces the amount of money circulating in the economy. Fewer dollars are chasing the same number of goods and services. So, even though the total quantity of goods and services hasn’t changed, some things become cheaper while others become more expensive.
As the value of money falls, the nominal interest rate rises. This is because the nominal interest rate is just the percentage of GDP that you earn per year. If the nominal interest rate rises, then the actual interest rate must fall.
The main reason why this happens is that the central bank needs to keep inflation low. To do this, they raise the base interest rate. But the base interest rate isn’t fixed; it varies according to the current level of inflation.
So, if the central bank raises the base interest rate, it lowers the inflation rate. This is because the base interest rate is set relative to the current level of the consumer price index (CPI).
The effect of high inflation on interest rates:
To control high inflation, the central bank raises the interest rate. As the interest rate increases, the cost of borrowing goes up.
When the interest rate rises, it becomes expensive to borrow money.
Hence, borrowing declines and the money supply falls.
A fall in the money supply leads to less money being spent on goods and services. People will purchase fewer goods and services.
This leads to lower demand for products and services.
As a result, businesses are forced to cut production.
Businesses cut down on production because they want to reduce costs. They do this to make profits.
Therefore, the economy shrinks.
The above process is called Say’s Law.
The effect of low inflation on interest rates:
If inflation is low, the Fed lowers the interest rate to stimulate economic activity. Lowering the interest rate makes it easier for borrowers to borrow money. As a consequence, the economy grows faster and employment increases.
What Is the Inflation Target?
Australia’s inflation target is to hold the level of consumer prices – measured by the Consumer Price Index (CPI) – within a band of 2% to 3% annually. This is referred to as the inflation target.
The particular measure of the consumer price index is the percentage change in CPI.
An inflation target provides a framework for guiding a central bank’s monetary policy decisions and ensuring accountability in its management of economic conditions.
In addition, an inflation target offers a useful benchmark against which to assess whether the performance of the economy is satisfactory.
Achieving an inflation target requires careful attention to the conduct of monetary policy and monitoring of the economy.
The Reserve Bank targets inflation because it wants to keep prices stable:
The Reserve Bank targets inflation to ensure it does not fall below 2 to 3 per cent. Achieving this goal requires careful management of money supply, interest rates, and exchange rates.
In recent decades, Australia’s central bank has been successful in keeping inflation close to its target. But there are risks to achieving this success. If prices rise faster than expected, it could lead to slower growth, unemployment, and lower living standards.
To avoid such outcomes, the Reserve Bank sets its policy framework to keep inflation within 2 to 3 per cent over the medium term.
How inflation and interest rates influence Mortgage loans:
Inflation can affect the home loan rate because the Reserve Bank of Australia uses the interest rate to sets the borrowing costs paid by banks and building societies to lend money to each other. If the RBA increases the interest rate to match the inflation rate, it is unlikely to impact your home loan rate because the RBA has already taken into account the impact of inflation on the price of housing.
However, if the RBA lowers the cash rate to keep pace with falling inflation, it is likely to lower house prices, which could lead to higher lending costs for borrowers.
Interest rates and inflation have different effects on mortgage loans. Interest rates determine how much people pay when they take out a loan.
Inflation affects the amount that people earn after they receive their initial payment from the lender. The higher the inflation rate, the more people can’t afford to spend on goods and services.
So, the higher the inflation rate, then the fewer people will be able to buy houses.
The opposite is true if the inflation rate falls.
When inflation is low, banks offer less interest on mortgages.
When inflation is high, banks increase interest rates.
So, the higher the inflation, the interest rate will increase.
The reverse applies when the inflation rate falls
Conclusion:
In conclusion, inflation can affect home loan rates, and this affects your home loan payment.
However, it’s important to keep in mind that inflation can also cause your home loan repayments to decrease over time.
We can say that inflation and interest rates are two important factors that influence the housing market.
They both play an important role in determining the value of your home.
However, inflation influences the overall cost of owning a house.
Therefore, you should always check with your bank or financial institution before taking out a mortgage.
Disclaimer: The information included on this site is for educational purposes only. Because of unique individual needs, the reader should consult their financial analyst to determine the appropriateness of the information for the reader’s situation.
