The US Federal Reserve officially lifted interest rates last week. Here’s why US interest rates matter to Australians.
By Matt Hopkins
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 (RBA) 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 at a higher rate. So when the cash rate is low, it makes borrowing money cheaper for both business and individuals.
Interest rates work both ways
When interest rates are high, people who have deposited money with the banks 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, the epitome of the everyman, 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 last week the US Federal Reserve increased their version of the cash rate. A change in US interest rates matter because they’ve been sitting close to zero since 2008 and a move up signals that Uncle Sam’s economy is healthy enough to handle a higher cost of money.
This decision to increase interest rates is based on inflation, the labour market and other economic factors.
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.
Higher interest rates will therefore see John Doe and his sailing mates move more 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.
As well as this, a lifts in US interest rates matter because they 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. They do this to earn the best rate of interest available. Higher interest rates on US dollars mean our mate Doey 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 good-ol’ petrol.
Will interest rates keep increasing?
The Fed says yes. It’s anticipated there will be further rate increases at each of the next six-monthly Federal Reserve meetings.
That means official interest rates in the US of 1.9 per cent (they are currently 0.25-0.5 per cent) by the end of the year, and three more hikes in 2023 to a peak of 2.8 per cent.
This reflects the Fed’s view that the strength of the US economy will continue. Annual economic growth was 5.5 per cent for the December quarter, which is the strongest since 1984. It has had massive government stimulus and inflation is rising sharply.
Our Reserve Bank will be watching the Fed’s move closely and will certainly follow suit. But our economic rebound is different to the US, which will affect rate rise timings and magnitude.
While in all likelihood the effects certainly won’t be catastrophic, it shows that increases in US interest rates matter. It pays to know how your financial situation will be effected, especially if you’re looking to take a dive into the property market, like Joe Blogs.