Have you ever wondered what
the Reserve Bank of Australia (RBA) is doing when they
increase interest rates?
The bottom line, to use a
catchphrase, is that every type of investment is related to
the cash rate set by the RBA.
To make a very simplistic
observation the interest rate which the RBA sets is a tool
which is used to fine tune investments and therefore the
flow of cash from one sector of the economy to another. In
any economy the flow of cash dictates the movement into or
out of investments. For example, to housing, to shares,
IBD's, superannuation
Currently the RBA has set
the cash rate at 4.5% which means that by putting cash into
a savings account, at simple interest it would take 22.22
years (100/4.5=22.22) to double in value. That figure of
22.22 is the P E ratio for cash at the RBA rate.
The P E ratio equates to
the number of years that it will take to repay the capital,
without taking into account growth or inflation.
If you shop around and
receive say 5.4% interest then the P E ratio will be 18.52
(100/ 5.4= 18.52).
Why do other institutions
offer more than the RBA cash rate? They know that there has
to be an incentive for you to move money to them and they
can use this money to invest to make a profit.
For shares there is the
factor of dividend yield to repay purchase price. A share
with a P E ratio of 16 would be paying a dividend yield of
6.25% (100/6.25 = 16)
So an investment with a P E
of 16 (years) is much better than one with a P E of 22.22
(years). But then you have to weigh up the risks and
consider your personal circumstances.
As I said this is a very
simplistic explanation. In reality such factors as the risk
of investment, income tax, currency movements and inflation
will also be considered before there is a decision to
invest.
This is how the RBA is able
to control inflation by encouraging or restricting the flow
of money to a particular investment sector.
