What are interest rates?

How do interest rates work?

Interest rates impact our lives in all sorts of ways, so it's important that we understand what they are and why they change.

It might sound a bit strange, but interest rates are just the price of money. It's the price the bank pays you for depositing your money into a bank account with them (usually a pittance!). And it's the price you must pay for borrowing money from the bank – in the form of a mortgage to buy a house.

When interest rates go up, money becomes more expensive. It costs more to borrow it, and you receive more for lending it. The bank might pay you more interest on a term deposit, but you'll probably take a hit on your mortgage, personal loan, or credit card.

Although the interest rates on financial products can differ in all sorts of ways – and even between competing financial institutions – just about all of them are in some way impacted by the cash rate.

What is the cash rate?

Banks have minimum reserve requirements that the industry regulators set. These rules force banks to hold a certain amount of cash (or other highly liquid assets) on their balance sheets in case there's a sudden run on the banks, and they need to cover their depositors.

To ensure they meet these minimum requirements, banks often borrow money from other banks to top up their reserves at the end of each day. But they don't get to do this for free – banks charge each other an overnight interest rate for lending these funds.

This short-term interest rate is called the cash rate. The central bank sets it, which is the Reserve Bank of Australia (RBA) in Australia.

What all this means is that the way banks (or other lenders) price their loans and deposits has at least some relation to the cash rate, as this is the amount they may have to pay to meet the additional reserve requirements that come with doing more business.

So, when cash rates change, it influences lenders across the entire credit market and creates ripples throughout the economy.

Why do interest rates go up?

Because of the close relationship between interest rates and the cash rate, interest rates on loans will generally rise in response to an increase in the cash rate.

As we just mentioned, the RBA sets the cash rate in Australia. The RBA performs many functions in the Australian economy, but one of its key responsibilities is ensuring price stability. It does this by making adjustments to the cash rate.

Central banks will typically increase the cash rate to fight high inflation levels. When the RBA does this, retail banks and other financial institutions will generally pass this increase on to their customers, increasing borrowing costs.

So, if you see reports that inflation is rising quickly, it likely means the interest rate on your mortgage will soon be going up, too.

What is inflation?

In economics-speak, inflation means that too much money is chasing after too few goods. People with more disposable income naturally bid up the prices of goods and services. This is particularly evident in the property market but also impacts everyday things like groceries, travel, and energy bills.

Supply disruptions can also cause price inflation. When there is a more limited supply of something, each unit of that thing tends to become more valuable. For instance, the oil price skyrocketed early in the Russia-Ukraine conflict as many countries banned the importing of Russian oil, restricting global supply.

The rate at which prices increase is called inflation. A higher inflation rate means that prices are rising quickly, while a lower rate means they are rising more slowly. Deflation is when prices are decreasing.

Calculating the inflation rate can be complex and subjective, as the prices of goods, services, and assets in the economy can change for various reasons. 

In Australia, the Australian Bureau of Statistics (ABS) provides the most widely accepted measure of inflation. It calculates inflation by measuring changes in the average price of a basket of everyday household goods and services, called the Consumer Price Index (CPI).

About the Consumer Price Index

The ABS categorises thousands of individual products and services into 11 broad groups to make up the CPI. It then weights these groups according to how much households spend on them.

For example, property has the highest weighting because it is the most expensive thing most individuals will purchase, so changes in property prices will have an outsized impact on people's cost of living.

Other CPI groups include food, recreational activities, and transport, among many others. The ABS calculates the weighted average annual price change across all these groups and updates it monthly and quarterly. The quarterly number is what most people quote when they're talking about inflation.

It's important to note that some level of price inflation in the economy is a healthy thing. It generally means the economy is growing, more people are employed, and companies are making profits and investing in new projects.

However, when inflation reaches high levels, your money loses its buying power more quickly. Your savings can't buy as much stuff as they could a year ago – in other words, your savings account is literally worth less.

If wage growth can't keep pace with inflation, it might force more people into poverty. This makes it vital for the RBA to keep inflation within acceptable low levels. The RBA's current target range is 2% to 3% annually.

How does inflation impact shares?

Generally speaking, inflation is bad news for shares, especially growth shares. Although people bid up the prices of assets during inflationary periods – and this may include financial assets like shares – it's important to remember that everything gets more expensive when inflation is running hot.

As a result, company costs also rise, and any cash they have set aside to weather a downturn may quickly decline. Growth shares are particularly affected because these companies are more likely to be highly leveraged junior companies with less stable revenue. This makes it less likely that they'll be able to cover continually rising costs.

Not only do costs rise, but the average consumer is spending less. Once inflation really starts to bite, households are forced to cut back on spending because their money simply won't go as far as it used to.

So, higher costs and fewer sales will inevitably squeeze company profit margins, which will be reflected in falling share prices and possibly even some business collapses.

How do rising rates impact shares?

The short answer is that rising rates, just like inflation, are usually bad news for shares. But let's look at the mechanics to understand why.

When economies quickly expand, people (and corporations) in those economies generally become wealthier. This results in them spending and consuming more, bidding up prices.

Left unchecked, this results in higher inflation. The central bank then needs to step in and increase interest rates to make money more expensive to borrow. This causes the economy to contract as households restrict spending and companies tighten their purse strings. 

This suppresses economic demand, reining in price growth and taming inflation.

Once inflation is controlled, central banks will lower interest rates again. This will reduce borrowing costs and encourage increased spending in the economy, which will lead to another expansionary phase, and the merry-go-round continues.

So, while periods of high inflation and rising interest rates can feel destabilising and create uncertainty at the time, it is all still part of a normal business cycle.

Interest rates can be a blunt instrument, though!

Higher rates make it more expensive for companies to service their debts, so highly leveraged businesses will struggle to stay afloat. In a worst-case scenario, some might default on their loans and become bankrupt.

This means that owning shares becomes increasingly risky as rates rise, and share prices will generally fall as a result. Essentially, high inflation and rising interest rates both tend to make people poorer – either by reducing their purchasing power or making it more expensive to keep up with their mortgage or credit card repayments.

Both of these things are bad news for businesses – and shareholders.

What are the worst share market investments during inflation?

As we've already discussed, growth shares are probably the worst investments when inflation is running hot.

Growth stocks are usually high-risk, high-reward shares. They may be companies that aren't yet turning a profit but promise massive returns once their products are fully developed. For example, they could be tech stocks attempting to revolutionise an industry or pharmaceutical or biotech stocks with promising drugs still in their trial phases.

Either way, investors generally buy these stocks based on their future potential rather than their current performance.

Companies like this generally thrive when business conditions are good, when inflation is benign, and when rates are low. They can borrow heavily to invest in research and development, knowing that money is cheap and costs are predictable.

However, when costs rise and interest rates go up, these are the companies most at risk of insolvency. Some aren't yet generating enough income to sustain themselves, and they are getting hit with higher input costs and higher interest expenses.

Why do rising inflation and interest rates hurt retired people?

Unfortunately, high inflation and interest rates tend to hurt retired people more than those still in the workforce. This is because retirees usually rely solely on their savings and investments to maintain their quality of life once they are no longer working.

When inflation is high, the money in your savings account depreciates in value. This means that the money retirees have saved throughout their working lives no longer buys as much as it used to.

When interest rates are high, retirees will receive more interest on their savings from the banks. However, because shares tend to lose value when rates are high, this will reduce the value of retirees' share portfolios, thereby reducing their overall wealth. 

If company profits are squeezed in a high-rate environment, companies may also cut back on dividends, a key income source for many retirees.

Why do the rich typically get richer in times of high inflation?

High inflation does not impact all parts of the economy equally. As we've just explained, retirees tend to be hurt significantly more than those still in the workforce. But there is one group in society that can benefit from high inflation: the wealthy.

Remember, inflation means everything becomes more expensive. This includes assets like property and many commodities. People who already own significant assets – the rich – may see the value of their assets increase during periods of high inflation. Meaning they get even richer.

And even if high inflation and rising interest rates force property values down, the wealthy typically will have enough of a capital reserve to buffer them through an economic downturn until the cycle returns to equilibrium.

On the other hand, poorer households with few assets, especially those who already live pay cheque to pay cheque, will be most impacted by rising prices. Their disposable income will decline, and they may no longer be able to afford their mortgage repayments or basics like rent, power and transport costs, for example.

This is why inflation can be so damaging. It further concentrates wealth among the few at the top, forcing more of those at the bottom into poverty.

The switch from growth to value shares

Earlier, we discussed that growth shares tend to suffer the most when inflation is high and interest rates are rising. Costs increase, and borrowing becomes more expensive, making it difficult for highly leveraged companies to survive.

However, while the prices of growth shares tend to tumble when inflation is high, one group of shares often holds up well: value shares.

Value shares are usually well-established companies with good fundamentals. They might have dependable revenues and healthy balance sheets and pay consistent, regular dividends. 

However, despite these positive qualities, investors often overlook them in boom times because they don't have the explosive potential of growth shares. When the economy is in an expansion phase, value stocks seem kind of boring.

But when the economy goes belly-up, it's often the most boring companies that have the best chance of survival. They've been around the block a few times and have the experience to navigate a crisis.

This means that in times of high inflation when financial markets can be particularly volatile, investors often switch their focus from growth to value shares. Value shares are considered a safe-haven asset when risk is high.

How can the government and central bank curb interest rates?

As we have discussed, the RBA is responsible for setting the cash rate in Australia. Although we haven't mentioned it so far, the RBA (and the central banks of other countries) can also increase or decrease the money supply by purchasing and selling government bonds. 

This strategy can also fight inflation, as making money scarcer increases its value, doing some of the work of higher interest rates.

When the RBA and other central banks perform these functions to stabilise prices and maintain the value of their nation's currency, it is called monetary policy.

There are a few levers that governments can pull as well. Governments can raise tax rates to decrease household and corporate spending if inflation is too high. They can also reduce spending on new projects and social enterprises, which can help cool the economy and fight inflation.

When governments carry out these activities, it is called fiscal policy.

The overarching goal for both central banks and governments is to maintain steady economic growth. Of course, there will always be periods when the economy is too hot or cold, but ideally, central banks and governments want to maintain and prolong that nice healthy 'goldilocks' phase.

Doing this keeps inflation within a consistent target range, and by extension, it also ensures the cash rate remains low.