Winners and Losers with Higher Interest Rates
Reading the newspapers, it seems that everyone hates higher interest rates. There’s good reason for that. Higher interest rates are supposed to reduce our spending power. But it’s a bit like medicine – a bitter taste now to make us feel better in the future.
Interest rates are a powerful tool with which to control the economy. When rates rise, borrowers have to pay more in interest. For households, this means there’s less money to spend on other things, so consumer demand is dampened. Many companies face a double-whammy. If they carry debt, as most companies do, the higher interest costs eat into their profits. The reduction in consumer spending may lead to lower sales, further decreasing profitability. As a result, companies reduce their investment in new equipment, buy less from suppliers and lay off staff – all of which contributes to a further decrease in economic activity.
So why has the Reserve Bank (RBA) increased official interest rates so aggressively in recent times?
The overriding concern of the RBA is to hold inflation at a rate of 2-3% pa, but with the Australian economy performing strongly, unemployment at low levels, and high demand for goods and services, underlying inflation was running at 3.6% at the end of 2007. That means the RBA is eying the interest rate medicine bottle again.
The main casualties of an increase in rates will be people who have borrowed as much as they can and don’t have the necessary cashflow to cope with increased loan repayments. In the worst case, they may be forced to sell their homes.
Companies with high levels of debt can also be placed in a precarious situation. Significant increases in interest costs can slash profits, thus reducing the value of the company. If the company is listed on the share market, shareholders will see a fall in the value of their investment.
Some borrowers will be able to cope with higher interest rates, which are a sign of an overheating economy. Many companies have had a good run lately, and higher profits are more than enough to compensate for higher interest expenses. The same applies to people who are benefiting from the shortage of skilled labour, and who have seen the salaries or wages increase.
Perhaps the main beneficiaries of higher rates are investors who hold interest bearing deposits. These may be term deposits, investment or cash management accounts, or mortgage trusts. In just two years, rates on three to four month term deposits have increased from around 4% to 7%. That’s an impressive 75% increase in income!
Data sources: RBA, Commsec, ANZ