First of all, let me commend you on jumping into this article.
Interest rates are admittedly a pretty dry subject and usually devoid of anything resembling fun, but ultimately they affect all of us, even if you think you’re way too cool to take notice.
Interest rates are finance speak for ‘the cost of money’.
The Reserve Bank of Australia establishes the cost of money by setting the value of what’s called the cash rate. This is the rate of interest which they charge on overnight loans to commercial banks.
Banks make a profit by borrowing money cheaply, and then lending to their customers a higher rate. So when the cash rate is low, it makes borrowing money cheaper for both business and individuals.
When interest rates are high, people who have deposited money with them earn more interest.
For example, John Doe is a wealthy man with an expensive suit, no debt and millions of dollars in the bank. The cash rate will ultimately determine how much the bank will pay him for keeping his money in their account. John would like to see interest rates rise so that he can earn more money without making risky investments (and buy more expensive suits).
On the other hand, Joe Blogs is the epitome of the everyman and just wants to borrow some money from the bank to buy a house. The interest rate on a home loan will dictate how much the bank will charge him to borrow that money. Joe wants interest rates to stay low so that it is cheaper for him to borrow.
Have I lost you yet? Of course not! That stifled yawn is just the excess excitement leaving your body.
The reason you should be interested in this conversation right now is because the United States Federal Reserve looks set to increase their version of the cash rate. US interest rates have been sitting close to zero since 2008 and a move up would signal Uncle Sam’s economy is healthy enough to handle a higher cost of money.
This decision to increase interest rates will be based on inflation, the labour market and other economic factors. This decision will also be big news.
Why should I care?
I’m glad you asked. A rate rise from the US Fed will have a number of knock-on effects that are likely to impact your wallet.
In the world of ties and cognac, shares are considered a relatively high risk investment. So if investors can earn a decent risk-free rate of return by holding their money in the bank, they’ll certainly do so with at least some of their portfolio.
As John Doe has his fingers crossed for, higher interest rates will see him and his mates move some of their money out of shares and into other interest rate based investments. More people like John selling shares will lead to lower prices which will probably nudge your super balance down, along with any other shareholdings you have.
A lift in interest rates will also affect the Australian dollar, which is already copping a trampling from China not wanting to buy as much of our cool stuff.
What this boils down to is those pesky investors moving their money again. Currencies are driven a lot by interest rates as people move money from dollars to yen to euros to earn the best rate of interest available. Higher interest rates on US dollars mean our mate Johnny Boy moves more of his money over there.
You can guess what happens here… The lower Aussie dollar will mean you dish out more cash for things like imported goods, travel and petrol.
Will it happen?
Maybe, but it’s a close call. The Fed will be meeting again in December to make a decision on whether they will raise rates now, or further delay the hike. It all depends on whether they think the economy can handle money costing more.
CommSec economist Craig James – who’s on to this stuff like brickies on a beer – warns that other central banks have made the mistake of raising rates prematurely in the past, failing to leave enough time for the economy to recover from the last financial crisis. So the Fed will be brewing on this thought when the time comes to make the decision.
While the effects certainly won’t be catastrophic, it pays to know how your financial situation will be effected, especially if you’re looking to take a dive into the property market. Or you’re John Doe.