3

My knowledge of how interest rates work (please correct me if I'm wrong) is that it is set by the Central Bank of a country.

They're supposed to be apolitical and independent and their decision should solely based on the CPI, which is determined by the changing costs of a basket of goods.

My question is why is CPI so low, like 3% in Australia when house prices has been rising at like 20% consistently since 2000?

Is house price actually taken into account when they determine CPI? Do they count the cost of renting in the basket of goods?

Cause people generally pay probably around 20-33% of their wage on rent and probably even more nowadays on mortgage repayment. Is the cost of money taken into account when they determine CPI?

  • Typically the housing portion of CPI is based on monthly housing costs (whether that be rent or mortgage payments). Housing prices may be going up, but if interest rates are low, the overall cost of housing may not be rising as much as you think. – Eric Petroelje Oct 5 '10 at 19:38
3

The Central Banks sets various rate for lending to Banks and Paying interest to Banks on excess funds.

Apart from these the Central Banks also sets various other ratios that either create more liquidity or remove liquidity from Market.

The CPI is just one input to the Central Bank to determine rate, is not the only deciding criteria.

The CPI does not take into account the house price or the cost of renting in the basket of goods.

One of the reasons could be that CPI contains basic essentials and also the fact that it should be easily mesurable over the period of time. For example Retail Price of a particular item is easily mesurable. The rent is not easily mesurable.

2

The setting of interest rates (or "repurchase rates") varies from country to country, as well as with the independence of the central bank.

There are a number of measurements and indices that central bankers can take into account:

  • Consumer Price Inflation (CPI): An official "basket" of consumer items is set and each month the price of these is compared to the previous month and the rate of inflation (/deflation) calculated. Each country varies, some include house prices (for a defined type of house) others include rental costs. There are even different types of CPI (urban vs rural plus different product mixes). It should be clear, given this variability, that different people could choose different (and both official and consistent) measures of CPI to suite their objectives. Given this "bias" it is essential that both central banks and statistics collection be impartial.
  • Producer Price Inflation (PPI): Companies prefer to keep prices consistent and so pass on costs (or benefits) to their customers fairly slowly. There can be quite some lag stored up at the factory-side of production that could result in tremendous inflation sometime in the future. PPI attempts to gauge how much stress is being built up in an economy that could result in price rises, employee layoffs or even insolvencies. It is, similarly to CPI, based on a basket of goods.
  • Money Supply: This is a measure of the amount of money available in an economy (and, again, there are numerous different definitions and baskets for analysis). A rapid growth in money supply but with minimal economic growth is likely to lead to increased PPI and CPI. Money supply can include credit demand. Credit spent on consumption is different from credit spent on capital. So money supply is simply an early indicator of potential trouble.
  • Exchange Rates, GDP and Unemployment: The legislature can instruct the Central Bank regarding which factors to prioritise in setting interest rates and monetary policy. Any set of criteria can be used and, aside from the majors listed above, exchange rates, GDP and unemployment are also commonly included. Increased interest rates result in higher yields and may cause an inrush of "hot" short-term investments which can cause the currency to strengthen (which may result in higher inflation from imports, or trigger local production owing to import substitution).

This is a limited overview but should give an indication of just how complex tracking inflation is, let alone attempting to control it. House prices are in the mix but which house or which price?

The choice of what to measure faces the difficulty of attempting to find a symmetrical basket which really affects the majority regularly (and not everyone is buying several new houses a year so the majority are ring-fenced from fluctuations in prices at the capital end, but not from the interest-rate end).

And this is only when the various agencies (Statistics, Central Bank, Labour, etc.) are independent. In countries like Venezuela or Argentina, government has taken over release of such data and it is frequently at odds with individual experience.

Links for the US:

And, for Australia:

1

I'm not intimately familiar with the situation in Australia, but in the US the powers that be have adopted an interventionist philosophy. The Federal Reserve (Central Bank) is "buying back" US Gov't debt to keep rates low, and the government is keeping mortgage rates low buy buying mortgages with the proceeds of the cheap bond sales.

While this isn't directly related to Australia, it is relevant because the largest capital markets are in the US and influence the markets in Australia.

In the US, the CPI is a survey of all urban consumers. If you're a younger, middle class consumer with income growth ahead of you, your costs are going to shift more rapidly than an elderly or poor person who already owns or is in subsidized housing, and doesn't spend as much on transportation. For example, my parents are in their early 60's and are living in the house that I grew up in, which they own free and clear. There are alot of people like them, and they aren't affected by the swing in housing prices that we've seen in the last decade.

  • There's one difference which is that the US Fed explicitly has a dual mandate (prices and employment) whereas the Australian Reserve Bank, in theory, has only an inflation mandate. In practice, both seem to take a holistic view. – poolie Nov 24 '10 at 1:03

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.