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Issue #1673      February 18, 2015

Interest rates down – winners and losers

The Reserve Bank of Australia (RBA) recently cut the official interest rate from 2.5 percent to a new record low of 2.25 percent, defying the predictions of many economic commentators. For some it is good news, for others such low rates are proving disastrous.

Interest rates are a key economic lever. They have an impact on every aspect of the economy, including the cost of living, jobs and living standards. There are many and at times contradictory impacts from movements in interest rates.

The decision was made in the context of relative slow economic growth, predictions that unemployment will rise, and surplus capacity in the economy will decline (demand for goods and services is not high enough). Export industries are having a tough time with a plunge in commodity prices (coal, iron ore, etc) and what the RBA sees as an overvalued dollar.

Workers

Lower interest rates reduce the cost of borrowing for investment, such as to start a new business, expand an existing enterprise or update technology to cut costs of production and sack workers.

For workers it makes payments on personal loans, such as to buy a car, cheaper. It can also result in a welcome reduction in monthly home loan repayments on a mortgage and make it easier to pay bills. The RBA want people to spend the savings to boost demand for goods and services, but that is unlikely with all the government cuts that are going on and job insecurity.

But life is never quite that simple. For example, in Sydney, where there is a shortage of properties and an influx of overseas buyers seeking to invest in Australian real estate, the market is on fire and largely unaffordable for first home buyers. Demand far exceeds supply.

If more people manage to enter the Sydney market as a result of lower interest rates, there are fears it could push up the price of homes even further, fuelling a large bubble that will eventually burst. When interest rates rise and the bubble does burst, the bank evictions begin as people cannot meet mortgage repayments.

In regional areas or cities such as Adelaide where prices are far lower, it might make it possible for more people to break into the market.

Interest rates of course can rise, posing dangers for those who stretched their budgets to get a home loan at a very low rate.

Changes in interest rates also flow on to the rental market – as many rental properties carry mortgages.

Retirees

But for retired workers, lower interest rates can mean good or bad news. If some or all of the lump sum they received on retirement is in fixed term bank deposits, then each drop in interest rates results in a drop in income.

The media talk in terms of a reduction of 0.25 percent (or 25 basis points). This might sound small, but it amounts to a loss of 10 percent in income. Just that one “small” reduction! For a retiree relying on income from fixed term deposits it is a significant loss of income.*

That 10 percent is serious enough. But take the example of a worker who retired six years ago, and put a large proportion of their lump sum into a five-year fixed term deposit. The official rate then was seven percent and the bank paid 7.5 percent or $7,500 interest on a $100,000 deposit.

A similar term deposit taken out today would result in an income of $3,000 per annum based on a rate of 3.0 percent.** That is a reduction of more than half in their income. For shorter term deposits the interest rates are far lower.

Not surprisingly, with each cut in interest rates more people begin looking at alternative places to put their money where the returns might be higher such as real estate and shares.

With interest rates at a record low and signals from the RBA that they will go lower, it is not surprising that first home buyers are competing with even more investors and that share prices are rising due to increased demand.

One of the main reasons for the RBA reducing interest rates further was concern over the value of the Australian dollar. It has fallen from over 100 cents to the US dollar to 77 cents in recent years but the RBA would like it to be even lower.

“It remains above most estimates of its fundamental value, particularly given the significant declines in key commodity prices. A lower exchange rate is likely to be needed to achieve balanced growth in the economy,” the RBA Governor said in a statement issued following the announcement of the rate cut.

The theory is that lower interest rates attract fewer investors and reduces demand for the Australian dollar and so its price (value) falls against other currencies. This makes Australian products cheaper for foreign importers and thus boosts our exports, which is the aim.

Conversely, a high dollar makes our exports more expensive (less competitive) and potential customers look elsewhere.

Real winners

At present banks are paying as little as 0.0 to 0.01 percent on some savings accounts and still charging whopping rates of up to 20 percent on credit cards. At the same time they continue to make billions out of fees.

At present the banks are awash with money, they are not all-out competing for local deposits. They can borrow on international markets at a fraction of the price they pay on deposits in Australia. The US Federal rate is 0.13 percent, the Bank of Japan rate 0.10, the European Central Bank 0.05 and the Bank of England 0.50 percent. At time rates have fallen below zero, meaning depositors are paying to park their money.

In general Australian banks are charging between four and five percent interest on new home loans, depending on the type of loan, and pay between two and three percent on fixed term deposits. The gap between the two (margin) is around 2.25 to 2.5 percent. The reality is that the margins (profits) are far larger because of the overseas borrowings.

There is speculation that interest rates in Australia are heading downwards too.

Whatever the outcomes for others, the banks stand to make billions more in profits.

* For those who like numbers: 2.5% of $10,000 is $250 in interest. 2.25% of $10,000 is $225 in interest. Drop in interest income is 250 - 225 = 25. 25 is 10% of 250.

** Interest rates on fixed term deposits tend to be higher than the official rate, and vary considerably with the term of the deposit.

NB, the above is a political article, it should not be used as financial advice.

Next article – COAG reviews land rights

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