The first thing which comes to people’s minds where they think about interest are the numbers on their bank statement telling them how much their loan is costing, or how much a savings or investment account is earning.
Most people won’t picture the role of interest rates in the wide economic environment – however interest rates are one of the favorite go-to tools of Australia’s economic regulators.
Why? It’s because economic regulators are very focused on economic inflation – and interest rates have a direct relationship to inflation. Having more money (credit) in the economy encourages inflation, less money (credit) in the economy encourages deflation.
If there is too much inflation and the economy loses its stability as the price of goods and services outpaces the growth in an individual’s buying power.
If there is too little inflation and the economy becomes stagnant, or worse recedes and businesses suffer, and workers lose their jobs.
That’s why the government likes to keep inflation within the sweet spot of 2-3% per annum.
As of January 2020, the current inflation rate is around 1.90%. If this number holds, $1 today will be equivalent in buying power to $1.02 next year.
This slight rate of positive inflation encourages people to invest in things like capital, assets, and business because these things will tend to gain value in line with inflation rates.
This gives people the impression that they are becoming wealthier and gives them more confidence about the economy and their financial future and as a result, they spend more and drive economic activity- strengthening the overall economy. This phenomenon has become known as ‘The Wealth Effect’.
Because of this effect interest rates also have a direct effect on stabilizing Australia’s dollar on the international money markets, helping to maintain employment levels and ensuring the economic prosperity and welfare of Australians.
To regulate the economy, regulators use the Consumer Price Index to measure changes in inflation. The CPI measures prices of basic everyday household necessities such as petrol, milk, bread, etc. to see if there is price growth across the board.
If high inflation is detected, then interest rates are raised to curb this. If no or low inflation is detected than interest rates are lowered to help stimulate the economy.
The changes in interest rate levels are most visible to loan holders, as Australian banks will usually pass down the interest rate changes made by The Reserve Bank of Australia on their customers.
Why is this important for you? Well since the GFC of 2008/9 the global economy has been flat. In response to this, countries across the world have all followed similar policies and have continued cutting interest rates in the hope of re-injecting life into their economies.
As you can see from the chart below, the RBA’s cash rate (otherwise known as the interest rate at which the RBA lends money to other Australian financial institutions) has followed suit.
There were temporary blips where interest rates were raised in the hope the economy could sustain them, but they have lowered again very soon afterward and since 2011 have been in unwavering decline.
It’s quite plain to see that Australia simply can’t sustain an interest rate rise, and as of January 2020 sits at just 0.75%. Many pundits are confident that the rate will continue to drop and hit 0%, or even negative rates!
Lower interest rates provide a mixed bag for those on the property ladder. On one hand, those with existing properties will benefit as the lower interest rates drive prices up further and reduce their interest repayments.
However, those without a foot on the ladder are somewhat disadvantaged. Even though they can get a loan at a lower interest rate, the size of their loan will probably need to be bigger as property prices get pushed up.
Even though we appear to be uncharted territory when it comes to these low interest rates, there is an age-old saying which seems as relevant as ever, the best time to buy real estate was yesterday. The second-best time is today.