Why do we still care about the Reserve Bank cash rate?

General Manager of Wealth, Josh Callaghan

Month after month, nine board members meet on a Tuesday morning in Sydney to review the key economic numbers and decide on Australia’s official cash rate. And every month for two years they have made the decision to hold the cash rate at 1.5%.

So, it begs the question, why are we still interested?

Along with each rate announcement, the Reserve Bank also releases the minutes of the meeting that essentially sum up their decision. It talks to the key factors that were considered, how those factors are trending and how they assess their impact on the Australian economy. It’s a monthly economic cheat sheet for investors to feel the pulse of how Australia is performing in critical measures like inflation, GDP, wages growth, jobs and property prices. It also covers the key international economic developments that may impact trade, growth or certain local sectors.

For finance nerds like myself, it’s like a new episode of your favourite show coming out each month. However, it can be easily skim-read with some practice, regardless of your level of finance knowledge.

You can check out the latest board meeting minutes at the RBA’s website.

Why is the rate important?

Perhaps the most logical and practical way that the cash rate affects consumers is through our mortgage repayments. As the cost of funding increases, the banks can hand that cost onto us, the consumers.

But for investors the cash rate has a much wider impact. It effectively represents the risk-free rate of return which is used in many models, such as the Capital Asset Pricing Model (CAPM), to calculate the price of a share.

Essentially, the risk-free rate represents the rate of return that investors can get without taking on capital risk, like in a term deposit. It sets the floor expectations for the risk-return trade-off, which other investments use as a reference.

When looking at another investment, investors should consider assessing the risk premium (return on the investment less the risk-free rate) and relative risk of that investment.

Let’s consider two investments, which look like this:

Return Risk Rating
Investment A 3% 1
Investment B 5% 2

And let’s just say Investment B is twice as risky as Investment A, so for simplicity I have labelled them with a ‘risk rating’ of 2 and 1 respectively.

If we map out this scenario and use the current Reserve Bank rate of 1.5%, we get the following:

Risk-free rate at 1.5%

As we can see in this example, when using this risk-free rate we can visualise a linear risk-return trade-off line. Investment A in this example might be considered to be reasonable investment as it sits on the trade-off line. However, Investment B might be considered too risky for the return. For a risk rating of 2, in this example, we would expect a return of 6% but at present Investment B is only returning 5%. Simply, double the risk should provide double the return.

Now, if the RBA cash rate was to rise to 2%, which in turn would also change the risk-free rate, we’d  get this:

Risk-free rate at 2%

We can see that due to the increase in the risk-free rate, both Investment A and B sit above the risk-return trade-off line which suggests that an investor may be taking on too much risk for that level of return. With a higher risk-free rate, an investment with a risk rating of 1 would now need to return 4%.

For more on risk-return trade-off check out Investing for Beginners: Part 2.

Investors take note

So, for savvy investors, next time you’re listening to the latest Reserve Bank announcement, pay extra attention to the words used. This may help you form up your own view of the direction of the economy. When the rate eventually does change, that may be the time to review the assets that you hold as you might be able to achieve a similar rate of return but at a lower risk.

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About Josh Callaghan
Canstar’s General Manager for Wealth, Josh Callaghan, has accumulated more than 15 years’ experience in banking and finance, with in-depth product knowledge across retail banking, stockbroking, life insurance, health insurance and superannuation. Josh’s experience combined with his passion for new technology and active role in the fintech community has positioned him as a credible thought-leader on the future of finance. Through his work at Canstar, Josh is striving towards a goal of creating a world where building and managing wealth is easy for all consumers.

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