Interest rate changes – does anyone win?
Interest rates have certainly been front and centre in the financial media headlines recently. And while the sentiment is typically negative, whenever there is a change to the official cash rate, there are always both winners and losers.
The onset of the Covid-19 pandemic resulted in governments across the world adopting some rather significant measures to help galvanise economies. A rather significant economic lever adopted by the Reserve Bank of Australia (RBA) during this period was to reduce the official cash rate to 0.10%. In addition, the governor of the RBA at the time assured Australians that they would not seek to increase the official cash rate at least until 2024 (a comment I’m sure the governor now wishes he had not made). Now, over 2 years later, we are seeing some of the longer term impacts of measures like these flowing through our economy.
What’s the Government’s role in interest rates?
Part of the Government’s role is to help ensure the economy remains strong and grows at a sustainable level. As part of this measure the Government seeks to achieve economic growth of between 2% and 3% per year.
Governments adopt certain measures to help influence economic growth via adopting either “Fiscal Policy” or “Monetary Policy” or a combination of both. Fiscal policy is typically where governments spend money, such as the annual budget, which directly influences how much money they wish to spend or inject into the economy.
Monetary policy allows the government to control the supply of money via the setting of interest rates. Typically, a high interest rate will reduce the supply of money, where a low interest rate will increase the supply (or flow) of money into an economy.
The RBA is in charge of setting interest rates based on economic data available to them, with an announcement made on the first Tuesday of each month (except January).
What influences Interest rates?
A word we’ve been hearing a lot lately is “inflation”, and we also keep hearing that it’s really high. Inflation is a measure of the general increase in prices of goods and services along with the fall in the purchasing value/power of money. Put simply, it’s the measure of increases to the cost of living. Some examples of high inflation we have experienced recently are:
- Petrol prices reaching record highs
- Iceberg lettuces at $10.00
- Significant cost increases for building materials
When inflation, or the cost of living, increases above the 2%-3% range, this tells the government that we are spending too much money and the economy is growing too fast – and if not controlled, costs will get out of control. Zimbabwe is a prime example of what happens when inflation is out of control.
As a result of inflation at levels above 3%, the RBA will start to increase interest rates to effectively reduce the supply of money. In other words, it makes money more expensive for people and businesses to borrow and therefore reduces what is available to spend or invest into the economy. This in turns helps to slow the economy and bring inflation back in line with the target 2%-3% target.
Whilst inflation here in Australia was at 6.1% for the June 2022 quarter, the RBA continues to increase interest rates and will do so until they can see the impacts of higher interest rates starting to reduce inflation over time. The RBA have openly stated they hope to bring inflation back into its normal range over a 1-2 year time frame.
Are high interest rates bad news for everyone?
Despite the negative messages surrounding interest rate increases portrayed in the media, there is more than one side to the current economic environment.
So who are the winners?
The real beneficiaries of high interest rates are people who hold cash either in the bank or via deposit instruments like term deposits. With a higher official cash rate, this should translate to higher cash rates on offer by banks and financial institutions across the board. And while this group may be winners now, we’ve had a sustained period of record low interest rates, so for a long time people in this category have been the losers!
If you do have investments such as term deposits, we are seeing a large degree of variance on offer between the banks at present. If your bank is not offering you a competitive rate it may be time to talk to us about an alternative bank to see what rates you can achieve.
And the losers?
Without great surprise, the losers from higher interest rates are people and/or businesses who borrow money to fund purchases of goods or investments. Higher interest rates mean higher repayment amounts, and therefore less borrowing power in general. As repayment amounts increase, less money is available for spending in other areas (which in theory slows that rate of inflation).
Certain strategies can be considered to help offset or reduce the impact of rising interest rate markets. For example, you may look at your repayment type (Principal & Interest or Interest Only repayments) or consider whether fixed or variable rates are the most appropriate. These are all valid questions to ask and the answers are really dependent on each person’s goals and circumstances.
Where to from here?
Whilst there are many factors that influence the official cash rate – and these factors are changing every day – it’s almost impossible to predict with 100% accuracy just how high interest rates will go. However, with the current low official cash rates and the continued high levels of inflation, it would be reasonable to expect interest rates to continue to increase at least in the short term.
Historic cash rate levels measured since August 1990 to August 2022 indicate the average cash rate in this duration to be around 5.00% – with the peak being 14.00% in August 1990, to the lows of 0.10% in November 2020. We are currently sitting at 1.85% so there is clearly some room to move!
If you have any questions, please contact the Propel Financial Advice team.
