A worldwide pandemic like COVID-19 will always dominate the news, however, there are many other hot topics that regularly make news headlines. In recent times think Olympics, elections, natural disasters, the royal family shenanigans – there is certainly no shortage of material for headline news. But there is one certainty in the world of media, no matter what else is going on out there – interest rates will always make the news.
Today we take a look at why.
What is interest?
When someone borrows money there’s a cost to that. There’s the principal or the original amount of money you borrowed, and the interest, the cost of borrowing that money
If I borrow $100 from you today and agree to pay you back $110 when I get paid, then the $100 is the principal, and the $10 is the interest. In other words, that $10 is the benefit you get from lending me the $100.
The cost of borrowing money was a lesson I learned early in life. When I was a kid I once borrowed $5 from my older sister so I could go to the latest Star Wars movie with my friends when it came out on Friday. The next day I would have to mow my neighbour’s lawn to pay her back $6. If you work it out, this was the equivalent of 7300% pa. My sister was a shrewd businesswoman.
So, we have learnt that interest is the total amount that you pay to borrow money (in addition to the principal or initial amount you borrowed). The interest rate is the percentage of the principal that you pay for the use of the money.
For example, if you take out a $100,000 loan from the bank and the interest rate on the loan is 4%, your interest at the end of year one will be $4,000. If the interest rate was 10%, your interest owed would be $10,000.
Above I outlined that interest is the cost of obtaining money now and repaying it at a later date. It makes sense that there should be a cost for borrowing money.
Interest rates are also a useful tool that allows the Government to influence the economy.
How does the Government control interest rates?
Each country has what is called a central bank. The central bank works with the Government to achieve the country’s economic goals. In Australia, our central bank is the Reserve Bank of Australia (RBA).
The RBA is responsible for formulating and implementing monetary policy, ensuring the economic prosperity and welfare of Australians. One of the main responsibilities of the RBA is to control interest rates. This is done by setting the official Cash Rate. The cash rate influences the price of borrowing money in Australia. The case rate is the interest rate that RBA will charge commercial banks for loans. Whilst commercial banks are free to set their own interest rates for borrowing, the rates that they charge on loans and offer on savings tend to be derived from the cash rate. This means that the RBA can use the cash rate to encourage or discourage consumer spending, depending on the state of the economy.
How does the RBA impact the economy through interest rates?
Changes to the cash rate affects other interest rates. Changes in these interest rates affect economic activity and inflation. Lower interest rates increase spending. An increase in spending encourages businesses to respond by increasing how many goods or services they produce. This in turn leads to increases in economic activity and employment.
Higher interest rates tend to moderate economic growth by increasing the cost of borrowing. This reduces disposable income and therefore limits the growth in consumer spending. Higher interest rates tend to reduce inflationary pressures.
Inflation is an increase in the level of prices of the goods and services that we buy. In my previous example I talked about going to see the latest Star Wars movie. In the 1980’s I only needed to borrow $5 from my sister to go and see Luke Skywalker battle Darth Vader. If I went to see that movie today, it would cost me $20. That’s inflation.
Positives of a low interest rate:
- Cheaper mortgages
Low interest rates on mortgages encourage first-time homebuyers to enter the market. They also encourage current homeowners to refinance mortgages at a cheaper rate. This saves them money on their monthly mortgage payments.
- Consumers can finance items more easily
Interest rates for cars, appliances and student loans become very attractive in a low-interest rate environment. Instead of paying off these loans at once, it may be better to borrow at a low rate and spend that money elsewhere or invest it to make more money.
- Business
Low interest rates allow businesses to borrow more cheaply to buy machinery and equipment, hire employees and address other items where money is required to grow their business.
Negatives:
- Savers earn less
Low interest rates provide lower income returns to savers whose main focus is the preservation of capital and income. This is because yields on savings accounts, certificates of deposit and bonds are very low.
- Inflation
Low interest rates tend to result in increased inflation. More money in the economy contributes to people spending more, and therefore demanding more products and services. A strong economy and high demand pushes up the price of goods and services – resulting in increased inflation.
- Potential housing bubble
A housing bubble is an increase in house prices fuelled by increased demand, speculation, and exuberant spending to the point of collapse. Due to the fear of missing out people are prepared to pay more and more until at some point there’s a correction, demand stagnates at the same time supply increases, this results in a sharp drop in prices – that’s what they call the bubble bursting.
- A liquidity trap
A liquidity trap is where the RBA lowers interest rates to encourage spending, but instead of spending people save their money, rendering the monetary policy ineffective. We have seen this lately as the uncertainty caused by COVID-19 has caused many people to save any extra money they have in the bank, rather than spend it or invest it for higher yields. Some ways the Government might get the economy out of a liquidity trap include raising interest rates, hoping the situation will fix itself as prices fall to attractive levels, or increased government spending.
And so summary, lower interest rates leads to more money in the economy and contributes to people spending more, and therefore demanding more products and services. However, a strong economy and high demand pushes up the price of goods and services. At this stage the RBA may decide to raise the cash rate to slow things down a bit and manage inflation so that it stays within a healthy range. Interest rates also impact our exchange rate which has a large impact on our economy, but that’s another story for another day.
We hope we have given a useful brief outline on why interest rates are, have, and always will be in the news.
