The economic picture over the past 18 months has been startling. To support the global economy during last year’s COVID-19 related shutdown, governments around the world took drastic action to prevent a global slowdown that could have rivaled the Great Depression. In Australia, this contributed to the cash rate dropping to a historic low of just 0.1%.

Maintaining a steady rate of inflation is a key part of a central bank’s activities. Over the long term, rising inflation is good as it is a sign that an economy is growing, and provides a compelling reason to invest or spend cash – because any capital that isn’t earning returns will lose value. If inflation rises too high then goods and services will become too expensive, so most central banks are tasked with maintaining an inflation rate of around 2-3% per year. And what’s the best way of maintaining steady inflation? Interest rates. Raising or lowering the interest rate for an economy should either boost saving or boost spending, which should, in turn, lead to a rise or fall in inflation.

Raising Rates

Increasing the interest rate raises the cost of borrowing for banks which encourages them to raise their own interest rates and subsequently, passing the increase onto consumers. This means businesses and individuals will find that their cash account interest rate increases, while borrowing is more expensive.

In theory, the increased interest rate disincentives spending in an economy, causing economic growth to slow. With more cash held in bank accounts (due to higher rates) and less being spent, money supply tightens and demand for goods drops.

Lower demand for goods should make them cheaper, lowering inflation.

Lowering Rates

Conversely to above, lowering the base interest rate drops the cost of borrowing for banks which encourages them to lower their own interest rates.  Businesses and consumers will then find that interest rates on both savings accounts and loans are low. So, borrowing and spending are attractive, but saving is discouraged.

This causes the economy to grow, widening money supply and increasing spending on goods and services. Higher demand for goods should make them more expensive, therefore increasing inflation.

Economies are rarely as simple as the above and a lot of other factors can come into play when interest rates are raised or lowered. Sometimes, a central bank faces low inflation and can’t lower interest rates, which is when it will consider Quantitative Easing or QE.

When inflation is rising faster than a central bank wants, they might try and combat it with an interest rate hike. If inflation drops below the target rate, they might lower interest rates accordingly.

Equity Markets

Australia has recently put yet another reporting season behind us, again steeped in uncertainty and over the past 12 months, we have seen strong performance in the stock market, despite the economic troubles brought on by Covid-19. While the stock market is not the economy, it is a leading indicator of where investors think the economy will go.

The stock market is forward-looking based on a company’s future earnings and in that sense, it is possible for the market to be less impacted by current circumstances if investors think there is a bright future ahead.

There is confidence in a good recovery from the losses brought on by coronavirus and with lower interest rates, stocks are becoming one of the ways investors are now hunting yield.

Understanding how all above the above elements of the economy interact is important, but as Glenn Fairbairn mentioned in his recent blog, history will show you that over the long-term markets always go up and short-term movements in the market should be largely irrelevant and at Hewison Private Wealth, we take a long-term approach to investing for our clients.

“Finally to all my fellow Melbourne supporters, it’s now been two months since our grand final win and as Max Gawn said on the podium, after 57 years of pain, it’s coming home.”

Chris C