Today, I am answering a subscriber’s question, Pat in Melbourne wants to know about the cash rate, what is it, and how it affects term deposits bank accounts, and shares. Great question Pat, thanks for writing in!
The cash rate is established by the Reserve Bank of Australia, the RBA as it’s known. It’s the central bank in Australia and in charge of all aspects of monetary policy such as currency, overall employment, and just the general financial prosperity of Australia. The RBA sets the cash rate which is essentially the rate that commercial banks such as Commonwealth Bank, Westpac, ANZ, etc can borrow money at. The RBA meets on the first Tuesday of every month to set the cash rate. To give you an idea the current cash rate is 0.25% which is quite low, the lowest I’ve ever seen in my lifetime, whereas a year ago, the cash rate was 1.0%. So the RBA meets to increase or decrease the cash rate depending on what they want to do with the economy.
If the RBA puts up interest rates that means that it’s trying to soften the economy, perhaps it’s growing too fast causing inflation it wants to bring it back a little bit so interest rates go up. Now that effect is twofold, it makes the cost of borrowing more expensive so your home loan interest rate may go up and if your interest costs are higher that then slows the economy but it also means that any interest that you’re earning on your bank accounts, high interest bank accounts and term deposits also goes up so you earn more interest income, however, if your home loan repayments are more expensive (the interest), the cost of borrowing money is more expensive, that’s usually more powerful, more costly, and will soften the economy.
When the cash rate is reduced, the RBA is trying to stimulate the economy. Generally, banks will pass some or all of the savings onto customers. So, home loan interest rates may go down when the cash rate goes down. Borrowings become cheaper and the idea is that people then borrow more money to stimulate the economy to buy household items or property.
With the cash rate being a lot higher 1 year ago (1.0% then vs. 0.25% now) it means that it was more expensive for banks a year ago to borrow money (to lend to customers) so interest rates for customer home loans were higher and interest rates for bank accounts, high interest accounts, and term deposits were also higher, so you were getting more
bang for your buck in terms of interest earnings but your home loan interest may have been higher. Over the last year, we’ve seen that the economy in Australia was a bit slow, then COVID-19 hit and really mucked around with the economy, so the RBA has been lowering interest rates.
The effect on bank accounts and term deposits
When interest rates are higher you might notice that you’re earning more money on your savings particularly with a high interest account or a term deposit which will generally pay higher interest than a regular everyday bank account, however, when interest rates go down, those rates also go down, so the income you earn on your investments (cash savings) goes down. You earn less.
The effect on shares
The relationship between the cash rate and the share market is a little more indirect. When the cash rate is reduced and interest rates are lower, the share market seems to do better, it seems to improve. That’s for several reasons:
- There may be more investors flocking to the share market if people particularly say retirees or those reliant on the income they earn on their cash savings, they may not be earning as much as they previously were on their savings so they may turn to other types of share based investments to chase a higher return such as the dividends that shares can pay which are usually much higher than the interest rate attached to any bank account, high interest account or term deposit.
- When interest rates are low (the cash rate is low), it means that it’s cheaper for people to borrow but also cheaper for companies to borrow so that can stimulate the share market.
- When comparing bonds to the share market (bonds are essentially fixed interest/term deposit for argument’s sake), when the cash rate is low they will not do so well because the interest that they pay will be quite low, so their ‘value’ will also low. Conversely, share markets may then be worth more. The ‘value’ of the share market might be higher purely because the bond market is low. So people go towards shares that then pushes up the share market (prices).
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Disclaimer: This information provided is general in nature. It is based on the knowledge and experiences of the author and not intended to be taken as financial advice. It does not take into account the objectives, financial situation or needs of you or any other particular person. You need to consider your financial situation and needs before making any decisions based on the information. You may have to modify the information and do further research, for it to suit your personal financial situation. Therefore, before acting on the information, it is recommended that you consider its appropriateness to your circumstances or consult a financial adviser, tax advisers or legal professional to assist you in doing this