When rates are low they can influence more business investment because it is cheaper to borrow. When rates are high or rising, economic activity slows. As a result, interest rate movements are also useful tools to control inflation.
The cash rate or headline rate you hear mentioned regularly in the media is the interest rate on unsecured overnight loans between banks. The Reserve Bank of Australia (RBA) sets the rate and meets every month, except January, to consider whether it should move up, down or stay the same. This rate then usually flows through to market interest rates causing, for example, mortgage rates to rise or fall.
Australia lagged other world economies when it came to increasing rates but since the rises began here last year, the RBA has introduced hikes on a fairly regular basis. Indeed, the base rate has risen by 3.5% since June last year.
Australian Cash Rate Target
While interest rates are the key monetary policy weapon to control inflation and dampen the economy, there can be a risk of taking it too far and causing a recession. Economic growth is forecast to slow to around 1.5% this year as high inflation, low consumer confidence and rising rates take their toll.
Winners and losers
Nevertheless, not all consequences of an interest rate rise are equal for investors and sometimes the extent of its impact may be more of a reflection of your approach to investment risk. If you are a conservative investor with cash making up a significant proportion of your portfolio, then rate rises may be welcome. On the other hand, if your portfolio is focused on growth with most investments in say, shares and property, higher rates may start to erode the total value of your holdings.
This underlines the argument for diversity across your investments and an understanding of your goals in the short, medium, and long term.
Shares take a hit
In addition, shares are viewed as a higher-risk investment than more conservative fixed-interest options. So, if low-risk fixed-interest investments are delivering better returns, investors may switch to bonds.
However, that does not mean stock prices fall across the board. Traditionally, value stocks such as banks, insurance companies and resources have performed better than growth stocks in this environment. Also, investors prefer stocks earning money today rather than those with a promise of future earnings.
There are a lot of jitters in the share market, particularly in the wake of the failure of several mid-tier US banks. As a result, the traditional better performers are also struggling.
Fixed interest options
At the moment, fixed interest is experiencing an inverted yield curve which means long-term rates are lower than short-term. Such a situation reflects investor uncertainty about potential economic growth and can be a key predictor of recession and deflation. Of course, this is not the only measure to determine the possibility of a recession and many commentators in Australia believe we may avoid this scenario.
What about housing?
Australian Bureau of Statistics data showed an annual 35% drop in new investment loans earlier this year. The consequent reduction in available rental properties has put upward pressure on rents which is good news if you have no loan, a small loan or a fixed-interest loan on the property.