Why interest rates are important
Confidence in Australia’s growth markets of shares and property are closely linked to the level and expected future movements in interest rates.
When interest rates fall, the cost of debt becomes cheaper which pushes up property prices, encourages spending and thus growth, and enables businesses to use less costly leverage.
Returns on fixed interest investments also become unsatisfactory (a phenomenon we are witnessing presently) which forces investors and often retirees into the more volatile asset classes.
Consequently, in order to be a successful investor in Australia, it pays to have an understanding of how and why interest rates are set, and what the roles of Central Banks actually are.
What is the role of a Central Bank?
“To take away the punch bowl just when that party gets goin’!” – William McChesney Martin, former Chairman, US Federal Reserve.
The party analogy is a pretty good one actually.
As the economy heats up companies generate ever-greater profits, excited speculative activity and booming asset prices increasingly become the order of the day. A Central Bank will look to raise interest rates to cut the party short (to avoid boom and bust), hopefully in a manner which slows the proceedings in a relatively orderly fashion.
On the flip side, if the economy struggles with a hangover from the good times, then Central Banks will look to cut interest rates in order to stimulate growth and avert recession or even depression.
In Australia over recent times we have seen a series of interest rate cuts from 4.75% to half-century lows of just 3.00% in order to maintain or stimulate growth in many of the non-mining sectors of the economy. Some have described these cuts are pre-emptive, anticipating a tricky period ahead.
Who are the Central Banks and what do they call their rates?
Where I grew up in England we had the famous Bank of England, which, confusingly, sets interest rates for the whole of the UK. Across the water, Germany has its Deutsche Bundesbank (which loosely translates as Federal Bank) and the US has its Federal Reserve, colloquially known as ‘The Fed’.
In Australia, we have the Reserve Bank of Australia down at Martin Place in Sydney, often known as the ‘RBA’.
Each of the banks sets what is known as a ‘base rate’ of interest. In Blighty we rather predictably call it the ‘bank rate’ and the jargon-loving Americans know it as the ‘Fed Funds rate’. Aussies tend to be straight-shooters so in Australia we commonly refer to the ‘cash rate’.
Effective from 5 December 2012, today’s cash rate is just 3.00% in Australia.
Usually countries have their own currency. In Australia we floated the dollar in 1983 (allowing it to reach the dizzy heights of 110.8 US cents in July 2011). Some countries, such as East Timor where I’m living at the moment, use the perceived stable currencies of other countries (US dollars) and this lack of control creates challenges for the Central Bank.
I remember John Major and the gang copping an awful lot of flak when Britain negotiated to stay out of the Euro in the 1991 Maastricht Treaty. Yet imagine the pain that Germany is going through today – interest rates are set by the European Central Bank (ECB) across a range of countries, some of which have massive 20%+ unemployment, others of whom are in a relatively healthy state.
Central bank targets and roles
I discussed in my post yesterday how Central Bank trends have changed over time from monetarism (controlling the money supply) towards inflation-targeting.
Today, the RBA in Australia has a monetary policy which aims for:
- the stability of the currency;
- the maintenance of full employment; and
- the economic prosperity and welfare of the people.
These objectives were set by the Reserve Bank 1989, and in 1993 the RBA introduced a target range of inflation of 2-3%.
The global financial crisis also saw Central Banks adopting new roles in order to support the ailing financial system. In the US, the Fed assumed responsibility for maintaining liquidity for financial institutions, fearing that the lack of available funds could lead the entire financial system into meltdown.
While the mechanism of the Fed being used as a ‘lender of last resort’ (some banks had failed and credit had dried up) did shore up the system from total collapse, it is likely that we will see increase regulation in the banking and investment banking systems as a trade-off, which may be no bad thing. Central Banks may wield further power as a result.
The blunt interest rate tool and the impossible balancing act
One of the toughest problems facing a Central Bank is that it must make decisions based upon historic data.
Take the RBA and its inflation targeting policy of 2-3%. The RBA receives quarterly information in arrears from the Australian Bureau of Statistics (ABS), but given that the effect of previous interest rate movements can take up to 18 months to flow through to the data, they face a near impossible task with the blunt tool of an interest rate decision.
Lower interest rates encourage spending and thus inflation, but will have numerous other impacts. For example, an interest rate that is lower than those seen elsewhere will often weaken the currency.
Although Australia’s cash rate is only 3.00%, this is comfortably higher than in the US (0.25%) or the UK (0.50%) and consequently investors in Australia’s financial products have driven our currency very high. Today the Aussie dollar buys as much as 105 US cents.
Unfortunately, the strong currency makes life extremely difficult for exporters and we have seen the painful impact on companies such as BlueScope Steel (BSL) and Gunns Limited (GNS), being redundancies and voluntary administration respectively.
Central Banks have other tools in their armoury. They can buy and sell government bonds in order to adjust the interest rates thereupon, and they can trade currencies in order to manipulate (sorry, ‘intervene upon’) exchange rates.
What will interest rates do to investment markets in 2013?
Interest rates are set by the RBA monthly, although, according to tradition, no meeting will be held in January. The markets deem another cut to just 2.75% in February to be a little less than a 2 in 3 chance at 61%.
ANZ believes that interest rates will be cut four more times to just 2.00%. The general consensus is that there will probably be two more interest rate cuts in order to stimulate housing construction and other non-mining sectors of the economy.
The cash rate in Australia directly impacts the rate at which lenders set their mortgage rates and thus there is a strong correlation between interest rate movements and property market confidence.
The RBA is all too aware of what effect a cash rate of 2.50% could have on property prices and has warned Australians that a return to double digit rates of growth would be undesirable and imprudent.
Property investors need to be aware that while Australia-wide growth in 2013 is likely to be moderate, some markets will fall in line with the ‘slow melt theory’ and others will grow sharply. As the RBA will use its blunt interest rate tool, it will be able to do little to stem markets which boom in value, so keep an eye out for what happens in markets with tight rental supplies such as Perth, Darwin and Sydney in particular.
According to AMP the lower interest rates are also expected to make 2013 a prosperous year for the Aussie stock market, although, or course, such short-term securities market predictions are usually to be ingested with a proverbial grain of salt.