What economic factors affect the economy and how do these affect our daily lives?

Welcome to Finance and Fury, the Say What Wednesday edition. This week’s question is from Raj.

“I would love to have an overview of how certain economic factors are interlinked and impact economies: Inflation, Forex rates, Oil prices, Trade imbalances, Fiscal deficit, Money supply, Repo rates, Yield curves and bond prices, Lending rates and Central Bank monetary policy”

Big topic – every one of these factors is related in one way or another – both to the economy and to one another

1. The economy is complex – incredibly interconnected and unfortunately for any economist or policy maker – incredibly hard to accurately predict – or accurately theorise about
   1. You can have theories about if one factors moves in one direction – it will affect others in another matter
   2. But a lot of this is theoretical – purely to it making logical sense based around models that were conducted in an isolated environment –
      1. The world and economy isn’t an isolated environment – change one input and down the road it is anyone’s guess what the 10^th order of effect may be
   3. That is the core issue of this sort of topic – any individual with specialised knowledge about the economy – whilst they will have more specialised knowledge than the average person – when compared to the economic decisions based around the individual’s self-interest – the expert will always fall short
   4. For example – I might know more economic knowledge than the next 1,000 people, but if the economy is made up of millions of people – well then their combined specialist knowledge in their own fields and the actions that they will take in turn due to this will result in any number of potential outcomes – ones that an expert cannot predict
2. And like with any complex system – which the economy is – it isn’t linear – so for one expert to say that adding $100bn into the economy through increasing the money supply will result in inflation of 1% might be what the theory says – technically isn’t possible to accurately predict – so it is anyone’s guess
3. For these episodes – we will take a different way of looking at this topic – when most people talk about the economy, they are talking about numbers and statistical measures – for example, how certain metrics affect GDP, or employment, or any range of numbers on a screen –
   1. But this isn’t the real economy – it is a statistical measurement which is cherry picked – did an episode on this three months ago – called “How accurate are economic statistics and do they really matter in our daily lives?”
      1. we are the economy – so to answer the question – will be focusing on the relation to these economic factors and the effect that they have to the individual in the economy
   2. Could go through the theory in relation to the economy – for example – that lower interest rates are meant to lead to GDP growth and inflation – but it is proving to not be the case – so looking at the individual level may be a better place to start
   3. Now – this is still going to be a generalisation – not every individual will act in the same way – but how they will be affected will be similar – depending on their situation
      1. For example – Think it goes without say that if interest rates go down and someone has debt – like a mortgage – their interest repayments will go down
      2. But what about someone without debt? That is either looking to get into the property market or has already retired and doesn’t have debt? Well – the outcome on them is worse – their savings aren’t earning anything and it is likely that the property market just got more expensive if they are trying to get into the market
   4. At the aggregate level – taking the sum of all individual decisions- you get the economic output – but each group of individuals will take different actions depending on their financial situation and what is best for them

This topic can be broken up into a few chunks –

1. Monetary and Fiscal side – how do things like inflation, money supply, lending rates – which are central banking monetary policy affect the individual in the economy which will be covered today –
   1. Then next week – how do things like the Yield curves and bond prices – then government spending as fiscal deficit affect the individual?
2. Real economy side – forex rates, oil prices and trade imbalances – made up of the daily economic interactions within the economy

To start with – on the monetary side

1. Inflation – this is one of the factors that affect individual choice – and in turn the economy
   1. How does the individual respond to inflation – generally – if it is low – not much of a concern
   2. In your own life, do you really notice if inflation of 1-2% is present each year? As long as your income growth or investment/asset growth goes up by more each year – do you really care?
      1. Inflation is one of those factors that if it is out of sight – it is out of mind – especially when it is in small increments that aren’t noticeable in the short term – obviously when you compare the prices of goods and services today to the 50s there is a massive erosion in the purchasing power of your money
      2. Inflation is like the concept of boiling a frog – someone times you don’t notice until it is too late
   3. Where inflation to the individual really matters is when hyperinflation – or at least higher levels of inflation materialise – as this starts to impact the individual’s behaviour
      1. We may start seeing inflation materialise in western nations – potentially on food – ill potentially cover this in another episode – as there are some interesting developments on the supply side – with food areas like rice and meats – need to do some more research on this
         1. If inflation kicks into the country – it may not be from the increase in the money supply to individuals solely – but a lack of supply
      2. When inflation of goods and services starts to rise – it creates further shortages – if you know that by the end of the week things may cost 10% more – you buy now – and stockpile
         1. This leads to a further shortage – and it starts to create a breakdown in the economy – as the nations medium of exchange is likely to lose its value – and when this happens – your economy’s function starts to slow or cease
         2. A barter system starts to emerge and there is a chronic shortage of goods – that creates black markets
         3. For instance – toilet paper – some have recently seen this be a rare commodity – well in countries with hyperinflation like Venezuela – it is an extreme luxury – better to use cash instead – roll of toilet paper costs 2,600,000 bolivars – which converted is about $1 Aud after the resent reset of the currency – as they keep knocking zeros off the denomination – first was 3 and then 5
      3. Thankfully we aren’t at this level of inflation – However – in western nations that are facing the opposite problem of potential deflation – inflation the statistic does affect our lives – due to the way monetary policy is conducted – through interest rate movements in response to inflation targeting
      4. How does a central bank control interest rates – money supply – this is what can reduce our purchasing power
         1. How does the creation of money occur – central bank creates central bank reserves for use by a commercial bank –
            1. The bank – and its shareholders have put up their own money which has been invested in government bonds – then the bank informs the CB that they would like some of the central banks reserves – it exchanges the collateral of the bonds for the cash – then it can lend based around a capital requirement ratio-
            2. Then additional cash is introduced into the economy through fractional reserve banking systems – involves banks accepting deposits from customers (on top of the injection of cash from CBs) and making loans to borrowers while holding in reserve an amount equal to only a fraction of the bank’s deposit liabilities – technically Australia doesn’t even have this – we have a capital adequacy requirement – so we technically have no reserve requirements – Statutory reserve deposits abolished in 1988 – and in theory our banks can lend endlessly – in practice – APRA regulate them to have about 10.5% as capital – but this capital can be debt that these banks issue – so they issue more debt in capital notes then lend based around this
         2. Money supply – creation of money is also conducted through open market operations – the Central banks determine how much money is required in the economy for interest rates to be set at a determined level
            1. Interest rates are indirectly affected by open market operations (OMOs), the buying and selling of government securities in the public financial exchanges
            2. OMOs are tools in monetary policy that allow a central bank to control the money supply in an economy
               1. Under a contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. 
               2. Expansionary monetary policy entails the purchase of securities and an increase in the money supply. Changes to the money supply affect the rates at which banks lend to one another, a reflection of the basic law of supply and demand.
            3. But how does a central bank – and by extension commercial banks create inflation in the economy – two ways – as remember – the definition of inflation is the price increase – I view it more as the devaluation in real terms of the purchasing power – but be that as it may – increasing newly created money to an economy has to flow somewhere – and when it does – it can have the effect of increasing prices –
               1. Price growth of assets – through CB policies like QE or OMO through banks’ lending money – the inflation of prices materialises in the growth of property and shares – what is considered hard assets
                  1. These asset classes can increase in prices outside of these monetary policies – however – they are accelerated when CBs get involved
               2. Then – Price growth in goods and services – this is what most people would be familiar with –
                  1. But IMO – these two prices increases – between property and goods and services can be counter initiatives

• You have a thing called thew wealth affect – the concept that if property or asset prices go up – people will spend more – as they feel wealthier –
  1. However – what about new entrants over time – they are just left with more debt – so might not feel that wealthy if they have $600k of debt

1. That is the difference in the intergenerational effects of these policies – my parents’ generation is probably very happy with these polices – buy a place back in 1990s to 2000s for $300k to $400k – now worth about $1.5m to $2m – that is a good return –these policies have helped them massively –
   1. This is part of the Australian economy – and why we are some of the wealthiest population on earth –
   2. But it has the potential to hamstring our economy moving forward – when the new generations have to take out $600k of debt to buy a standard house – that is a lot of debt that needs to be paid back
   3. Give me 15% interest rates when the average loan was about $80k in the early 90s compared to $600k of debt at 2.5% interest rates – 6 times less interest but more principal
   4. With $80k – repayments of $1,012 p.m. – total repaid of $365,160 – pay back the $80k with $284,160 of interest
   5. With $600k – repayments of $2,371 p.m. – Total repaid $853,461 – pay back $600k with interest of $253,461
   6. But the catch here – and important to remember – the high interest rates of 15% or 17% lasted about 2-3 years – dropped down to 10%, then 7% within a few years – so a drop of 10% in a matter of 5 years –
      1. But even if interest rates had stayed the same at 15% – I would take that over todays economic situation
      2. In real terms – with inflation compared to the 1990s to today – $1,012pm is $2,027 to today – or about $350 less p.m. than what you would have had to pay in the 90s
   7. This means less money in real terms to put towards the economy in spending
2. Inflation itself isn’t a great measure – talked about it plenty in the past – however it is what is used as the measure on which monetary policy is conducted
   1. Looking at the flow on effects of this – on A yield curve – which is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity
   2. Look more at this in the next SWW episode – as bonds and yield curves as a pretty complex topic and takes a while to unpack – as it incorporates interest rates as well

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