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Happy (belated) Birthday Low Interest Rates

A very unusual thing happened earlier during August this year. Our historically low interest rates enjoyed their second birthday. That’s right: the Reserve Bank of Australia (‘RBA’) has now left interest rates unchanged since August 2016. The smart money is betting that a third birthday is almost a certainty.

Tuesday is not just a day for half-price movie tickets. On the first Tuesday of each month, the nightly news always includes a story about interest rates. (You will not be surprised to learn that this stops financial advisers like us going to the movies on that night – staying home and watching the news is much more exciting!)

The monthly news story tells us what the RBA is doing with interest rates. The RBA meet on the first Tuesday of each month – even on Melbourne Cup Day. The race that stops the nation does not stop the RBA – although they do get their meeting out of the way in the morning, well before the horses jump.

The RBA’s monthly meeting is where it sets its target for interest rates throughout much of the economy. It does this by setting a target rate for one particular interest rate, known as the ‘cash rate.’ The cash rate is the rate at which banks lend each other money on an overnight basis. By setting a target price for this market, the RBA affects the other major markets in which money is borrowed or lent. Lending markets are all inter-linked, so an impact in one has a flow-on effect in others.

The RBA influences the market for overnight lending by participating in the market. The RBA borrows or lends money in order to achieve the desired effect on interest rates. It is a lot like buying and selling in any market: if you flood the market with supply (in this case, money to lend), prices fall. If you buy up everything in the market, prices rise. Remember: interest rates are simply the price of borrowed money. So, the RBA can influence the price by buying or selling within the market.

Of course, given that everyone else in the market knows what the target cash rate is, the RBA does not actually have to do too much buying and selling. If everyone knows what the price should be, that is the price they trade at as well.

Interest rates are low at the moment. This is known in the trade as ‘monetary easing.’ This has been happening for several years now. Monetary easing is generally good news for borrowers. The reason is simple – the price of their loans is lower. It is not such good news for lenders – they get paid less for the loans they make. Remember, you are a lender yourself if you have money on deposit with a bank.

The only interest rates that are not really impacted by monetary easing are credit card rates. Credit cards operate according to a very different set of market forces – particularly to do with naivete on the part of credit card users.

Monetary easing is designed to stimulate the economy. If people borrow and spend more, economic activity gets a boost. So, falling interest rates tend to be a sign that the economy needs a boost – which is why lower interest rates are not necessarily the good news that you might think.

The opposite of monetary easing is ‘monetary tightening.’ This is where interest rates rise. Rising interest rates discourage borrowers. This discouragement slows down the economy: higher interest rates mean less borrowing which in turn means less spending. So, higher interest rates tend to be a sign that the economy is going well.

This makes the announcement this week – the two-year anniversary of low interest rates – a very interesting situation. On balance, combined with generally lower house prices, the announcement is good news for first home buyers or upgraders. Their next home is now more affordable. But other people, such as retirees on fixed incomes, are not so happy – their purchasing power is dwindling as they receive lower returns.

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