The general level and the outlook for future interest rates have a significant effect on the prices and yields of fixed income products. As a general rule, when interest rates fall the value of fixed income products rise and vice versa. Therefore, it is important to have basic understanding of some of the main factors that influence interest rates in the economy.

Economic growth

Interest rates tend to move in sync with the rate of economic growth in the economy. The economy experiences periods of expansion and contraction at different times and of different magnitudes. Broadly speaking, when an economy expands there is an increase in the demand for funds. This puts upward pressure on interest rates. Interest rates will tend to rise constraining further growth and preventing the rate of inflation from rising too sharply. The economy then starts to contract and interest rates will start to fall to stimulate demand for funds and the expansion of the economy. These interest rate movements will affect the value of fixed income products.

Inflation

Keeping a close watch on the inflation rate is important for all investors. Inflation is a general measure of how quickly the prices of goods and services are rising in an economy. Rising prices erodes the value of our money which is why the key objective of most central banks is to control the level of inflation in the economy using monetary policy. When an economy grows strongly, inflation can start to rise. To stop inflation from rising too quickly, the Reserve Bank of Australia will increase interest rates. Expectations about inflation are a powerful influence on interest rates. Rising interest rates cause the prices of fixed income securities to fall and vice versa.

Balance of payments

The balance of payments records Australia's trade with the rest of the world. If Australia imports more than it exports this will lead to a balance of payments deficit and overtime if this situation worsens it can lead to an interest rate rise.

Demand for and supply of credit

Interest rates represent the price of money and therefore it will reflect general levels of supply and demand for credit in the economy as a whole. Major borrowers in the economy include the Government and the corporate sector. Major lenders include households and the international sector. If the demand for credit exceeds the supply of credit, this will put upward pressure on interest rates making them rise. If, on the other hand, the supply of credit exceeds demand then interest rates will fall.

International interest rates and exchange rates

In the deregulated global economy, interest rates and exchange rates are closely linked. Flows of international capital of the large institutional investors are significantly influenced by the interest rates and exchange rate differentials of the various economies. To attract international capital flows for investment funding, Australia's interest rates and exchange rates may rise or fall depending on the particular circumstances.