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.

If you have further questions or comments contact the author Jim Gleeson

Deciphering Political Speak laced with Financial Jargon

The jargon in the recent Australian Federal Budget is very confusing, isn’t it?
• The Government is saying that they predict that the budget will be in surplus in three years time.

Whereas
• The Opposition is saying that it is impossible to have the budget ‘back in the black’ by then.

Incidentally, both are correct in their assertions, but they are talking about two entirely different set of circumstances. The Government in referring to ‘the budget’ is actually talking about a Trading Account whereas the Opposition in talking about ‘the budget’ is talking about a Balance Sheet. Both are vitally important in any business and it is for this reason that a lender will ask for both, as to only see one or the other gives a distorted view of an enterprise.

The Federal Government is actually saying that their Trading Account will show a profit in three years time whilst the Opposition is saying that this profit will not be enough to repair the Balance Sheet and put it ‘back in the black’ by repaying over $100 billion in debt by then.

Examples of Jargon Confusion from Tuesday 11th May 2010

The Australian Government was saying two things in their budget comments

1. The budget will be in surplus in three years time
2. The budget will return to surplus by then because of higher tax revenues

Of course they are talking a yearly budget or annual budget which could be described as a *Trading Account.

The Australian Opposition is saying in response
• The budget cannot possibly be ‘in the black’ in three years
• That any surplus from the budget will only repay a fraction of the Australian Debt.

But they are talking **Balance Sheet .

As I said earlier both are correct because they are talking about entirely different things that sound the same.

Why couldn’t they just say that?

Jargon definitions.
* A budget is a tool to predict with reasonable accuracy whether the enterprise will result in a profit, a loss or will break-even A budget is often compiled annually and called a Trading Account.
**A Balance Sheet is a summary of financial balances (including debts not yet due). A balance sheet is often described as a “snapshot of financial conditions “.

These comments are sparked by last night’s Australian Federal Budget and are not politically motivated and only comment on the financial jargon used.

by Jim Gleeson