This week, my reading online has been focused on interest rates.
“Why interest rates?” I hear you ask with a yawn. Well, the RBA announced on Tuesday that it was to keep interest rates on hold at the official cash rate of 2.5%. A position it reviews on the first Tuesday of everyday month.
This week instead of being swept up in the hype of what the RBA has determined, I have spent time reflecting on the role interest rates play in our economy and why markets are fixated on their movement.
A good place to start is to understand how interest works and after a simple Google search I found this easy to read article – “How Interest Rates Work”. Basically an interest rate is the cost of borrowing money.
The article explains that in theory if the Fed or in Australia’s case the RBA, lowers interest rates, banks in turn are able to lower interest’ rates and banks will lower the rates offered to individuals and people are able to borrow money at a cheaper price. With money being cheaper it is expected that more individuals/companies will borrow, spending and investing will increase and the economy will grow.
From an investing prospective if federal interest rates are low, stock markets will respond positively, because it is a sign to investors that people will be buying more goods and services and companies will ramp up production.
At the moment there is much debate around whether interest rates actually have any effect on the economy. The article: “Interest rates don’t matter?”, looks at a survey of CFOs and their views on interest rates. The article outlines that CFOs at present do not really make decisions based on interest rate changes. One explanation for this may be that interest rates are already very low. Consequently, rates have less room to stimulate spending when they are already so close to zero. History shows that dramatic changes in interest rates are really the biggest catalyst to market responses. So, the incremental changes we have seen over the past couple of years have had little effect.
From my reading this week, to me it is obvious that long term low interest rates could be viewed as a negative. In that our economy is not growing and inflation is higher than the average. This poses the question of whether sustained low interest rates actually stimulate our economy: do they in fact stimulate jobs growth and achieve better return on investments?
As geeky as it sounds, over the next couple of years I will be watching to see if an increase in interest rates will have a positive effect on markets. As compared to the traditional view of it being a negative. I will be eagerly watching with the assumption that increased interest rates indicate a growth in the economy which is better for jobs growth and investments. Finally, it all leads me to wonder is there an interest rate sweet spot?