What Is the Cash Rate and How Does It Affect Interest Rates?

What Is the Cash Rate and How Does It Affect Interest Rates?

Reading time: 9 minutes

Cash Rates: The Basics

The cash rate, often termed the ‘benchmark’ or ‘official’ interest rate, is the most important monetary policy lever. It’s typically referred to as the cash rate in Australia, the bank rate in the UK, and the federal funds rate in the US. You may also see it referred to as the ‘overnight money market interest rate.’

Established by central banks, such as Australia’s Reserve Bank of Australia (RBA) or the US Federal Reserve (the Fed), this rate dictates the target overnight interest rate between commercial banks. Cash rates are decided on a regular basis, often monthly.

But why does this matter?

Well, the cash rate helps steer the economy. When a central bank adjusts the official cash rate, it aims to stimulate or slow economic growth by controlling borrowing and spending. These rates trickle down through the financial system and eventually affect citizens’ savings, mortgages, credit cards, etc.

The Connection Between Cash Rates and Interest Rates

Put simply, the cash rate determines the cost of borrowing for banks. When the cash rate increases, borrowing costs rise for these banks, which are typically passed onto consumers in the form of higher interest rates. Personal loan rates, home loan rates, and credit card repayments begin to climb, making borrowing less affordable.

However, when the cash rate drops, borrowing generally becomes cheaper. At the start of the COVID-19 pandemic, for example, the cash rate fell to 0% or near-0% in many countries in an effort to encourage spending and business investment, hence the stock market boom throughout 2020 and 2021.

But the cash rate also affects saving deposit rates too. Many savings accounts are variable-rate, generally meaning that the higher the cash rate, the higher the returns on savings and vice versa. This is because, while the cash rate also affects borrowing costs for banks, it also sets the rate of return for their own deposits. Cash rate hikes improve their returns, which may be passed on to consumers through higher savings interest rates.

Factors Influencing the Cash Rate

Central banks generally adjust the cash rate in response to three main economic factors: inflation, employment, and economic growth.

Inflation refers to the increase in the price of goods and services in an economy. Central banks typically set an inflation target of 2%; increased inflation negatively influences the purchasing power of its citizens, while lower inflation can increase purchasing power, though deflation might kick in (negative prices). If inflation becomes too high, they will raise the cash rate to quell borrowing and spending, which reduces demand and helps inflation ease.

Central banks also aim for full (natural) employment. If Australian unemployment creeps up, the RBA cash rate, for example, might be lowered to encourage investment and spending, potentially creating more jobs as a knock-on effect and kickstarting economic activity.

As mentioned, central banks can use interest rate changes to grow or slow down the economy. This is directly related to inflation and unemployment. An overheating economy often sees inflation grow in tandem with low unemployment, while a declining economy will usually see unemployment spike alongside weak inflation. In either scenario, central banks will use the cash rate to recalibrate the economy’s trajectory.

Beyond these primary factors, central bank economists monitor global financial events, geopolitical tensions, and market stability. These external factors can influence the domestic economy and, therefore, cash rate decisions.

Real-world Impacts of Cash Rate Changes

• Businesses and Households:

When the cash rate rises, businesses often face higher operating costs due to lenders demanding greater repayments. Expansion plans may be delayed or shelved. For households, this can mean pricier mortgage rates and a potential squeeze on disposable income. Conversely, a reduced cash rate can make borrowing more attractive, encouraging investment and consumer spending.

• Financial Markets:

Interest rate fluctuations can significantly impact the stock and bond markets. Generally, higher rates suppress bond prices while potentially reducing company earnings and dampening stock valuations. Conversely, lower interest rates can drive investors to riskier assets, boosting stock prices.

• Currency Values:

Currencies often appreciate in the face of rising interest rates since their native assets can offer better returns for foreign investors. Low interest rates might make a currency less attractive, leading to depreciation.

Tips for Traders and Investors

With the driving forces and effects of cash rate changes in mind, let’s look at a few tips for your trading or investing strategy.

• Stay Informed: Regularly monitor central bank announcements. Their language and forecasts can show you where rates may be heading in the short term.
• Understand the Effects: You may want to adjust your strategy depending on the assets you trade or invest in. For instance, rising interest rates often lead to stocks falling, while money market funds may outperform. Differences in cash rates (the interest rate differential) between two economies can often strongly predict long-term exchange rates.
• Diversify Across Sectors and Geographies: Not all sectors or regions react uniformly to rate adjustments, offering diversification opportunities. Banks, for example, may see greater earnings due to a higher cash rate.
• Analyse Historical Patterns: While past performance doesn't guarantee future results, understanding historical reactions to rate changes can provide context and potential scenarios.
• Consult Experts: Consider seeking advice from financial analysts or professionals, particularly when uncertain about the potential impacts of shifting rates on your investments.

The Bottom Line

The cash rate is instrumental in an economy’s overall direction and stability. It impacts everything from household expenses to global investments, and it is one of the most important factors to consider when gauging a given asset’s future direction.

Understanding its determinants and effects and reacting accordingly is crucial for individual financial planning and broader investment strategies. Whether you are a homeowner, business owner, trader, or investor, keeping a keen eye on the cash rate can help you navigate the financial tides successfully.