Impact of Changes in Interest Rates
Expert reviewed • 14 August 2024 • 8 minute read
Interest rates are a crucial tool in monetary policy, wielded by central banks to influence economic activity and stabilise the economy. The Reserve Bank of Australia (RBA) adjusts the cash rate to manage inflation, support employment, and promote economic growth.
Recent Interest Rate Trends in Australia
Before exploring the impacts, let's examine recent interest rate trends in Australia:
- The cash rate was cut to a record low of 0.10% in November 2020 in response to the COVID-19 pandemic.
- It remained at this level until May 2022, when the RBA began increasing rates to combat rising inflation.
- As of July 2023, the cash rate stands at 4.10%, reflecting a rapid tightening cycle.
What has Been the Impact on Economic Activity?
Consumer Spending
- Lower Interest Rates: When interest rates are lowered, the cost of borrowing decreases. This encourages consumers to take out loans for big-ticket items like homes and cars, leading to increased consumer spending. Conversely, lower rates reduce the incentive to save, as the returns on savings accounts and other fixed-income investments decline.
- Higher Interest Rates: When interest rates rise, borrowing becomes more expensive, which can reduce consumer spending. Higher rates also increase the attractiveness of saving, as returns on savings accounts and other fixed-income investments improve.
For example, retail trade turnover in Australia grew by 12.2% year-on-year in March 2022 when interest rates were low. However, growth slowed to 4.2% year-on-year in May 2023 as interest rates increased.
Business Investment
- Lower Interest Rates: Reduced borrowing costs encourage businesses to invest in expansion, new projects, and capital improvements. This can lead to increased production, job creation, and economic growth.
- Higher Interest Rates: Increased borrowing costs can deter businesses from taking out loans for expansion and investment, potentially slowing economic growth and job creation.
For example, private new capital expenditure in Australia grew by 9.3% in the 2021-22 financial year when rates were low. However, growth slowed to 2.6% in the March 2023 quarter as rates increased.
Housing Market
- Lower Interest Rates: Lower mortgage rates make home loans more affordable, stimulating demand in the housing market. This can lead to higher home prices and increased construction activity.
- Higher Interest Rates: Higher mortgage rates can dampen demand in the housing market, leading to lower home prices and reduced construction activity.
For example, Australian housing prices increased by 22.1% in 2021 when rates were low. However, prices fell by 8.4% in the year to May 2023 as interest rates rose.
Unemployment
- Lower Interest Rates: Lower rates can stimulate economic activity. As a result, businesses increase production and consequently have to hire more employees. This reduces the overall unemployment level.
- Higher Interest Rates: Higher rates may lead to higher unemployment if they significantly slow economic growth.
For example, Australia's unemployment rate fell to a 48-year low of 3.4% in October 2022, following a period of low interest rates. It has since risen slightly to 3.6% in May 2023 as rates increased.
Inflation
- Lower Interest Rates: Lower rates can encourage increased spending in the economy. As a result of increased demand, prices in the economy increase. Thus, higher inflation is caused by the stimulation of economic activity.
- Higher Interest Rates: Conversely, higher rates have the opposite effect. Instead of stimulating economic activity, high interest rates cause a decrease in demand, hence a subsequent decrease in prices. As a result, they are often used to combat high inflation by cooling economic activity.
For example, Australia's inflation rate rose to 7.8% in December 2022, prompting the RBA to raise interest rates. By March 2023, inflation had moderated to 7.0%, partly due to the impact of higher interest rates.