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Intermediate · Lesson 1 of 5Central banks and interest rates
Central banks such as the Reserve Bank of Australia (RBA) and the US Federal Reserve set a short-term policy rate to keep inflation near target (2-3% in Australia, 2% in the US) while supporting employment.
Rate rises make borrowing dearer, cool spending and usually pressure share valuations, especially for long-duration growth companies whose profits are far in the future. Rate cuts do the opposite. Banks' profits depend on the gap between lending and deposit rates, not just the level of rates.
Markets move on surprises, not announcements: a widely expected rate rise is already in prices. Watch market-implied rate expectations (cash-rate futures) and central bank statements for changes in tone.
Key takeaways
- RBA targets 2-3% inflation; the Fed targets 2%.
- Higher rates usually weigh on valuations, especially growth stocks.
- Markets react to surprises versus expectations.
Check your understanding
1. The RBA's inflation target band is...
- 0-1%
- 2-3%
- 4-5%
- 10%
Show the answer
2-3%. The RBA targets 2-3% on average.
2. A rate rise that markets fully expected usually causes...
- A huge crash
- Little reaction
- A dividend cut
- A currency peg
Show the answer
Little reaction. Expected news is already in prices.
Go deeper
- Wikipedia: Reserve Bank of Australia
- YouTube videos: how interest rates affect the stock market
- Investopedia: interest rates stocks
- Wikipedia: Federal Reserve
- Reserve Bank of Australia: education monetary policy
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