The devastatingly simple way to play the interest rate cut

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The Reserve Bank of Australia shocked most observers this week, dropping interest rates by half of one per cent.

With output below trend (partly due to a high Australian dollar) and inflation well under control, the RBA took the view that lower rates would assist economic growth without pushing inflation up too far.

Of course, the RBA's job is to provide the necessary expansionary or contractionary stimuli to keep the economy on an even keel. In less theoretical terms, its job is to moderate both the booms and the busts.

Bank margins likely to fall
The conventional wisdom – which usually holds true – is that lower rates mean lower bank margins, especially given the RBA rate is dropping more quickly than the rest of their funding costs.

As much can be seen from ANZ's (ASX: ANZ) earnings this week. The headline shows profit growth, but underlying profit grew more slowly.

Most importantly, the bank's net interest margin – the difference between its funding cost and the rate it charges borrowers – is being squeezed. The same thing is happening at Westpac (ASX: WBC).

Be careful what you wish for
It's a generalisation, but these industries (and our retailers) tend to decry every rate hike, and argue hard for every reduction.

For the sake of our economy and long-term prosperity (and investment returns) we should be going to bed every night thanking our lucky stars that the RBA doesn't bend to the will of these interest groups who would simply have it 'kick the can down the road'.

If Greece and the US housing market have taught us anything, it is the accuracy of the old adage that an ounce of prevention is worth a pound of cure.

Consumer confidence
Many of our retailers (and likely the RBA) believe consumers have been reluctant to spend, as they are impacted by the news from overseas and are reacting by shoring up personal balance sheets.

Credit growth is sluggish, as is house price growth. It's hard to escape the feeling that people are simply going back into their shells while they wait for the storm – real or imagined – to pass.

Shopkeepers will be hoping that lower rates entice consumers back to the stores, especially those in the discretionary retail space such as Myer (ASX: MYR) and JB Hi-Fi (ASX: JBH).

How to invest
As investors, how should we react?

The answer is that we should simply take it in our stride and not be distracted. Remember, the market is inherently cyclical. We should expect booms and busts, rate hikes and cuts. It has ever been thus.

In the last 10 years, we have seen no fewer than 28 moves in interest rates – 9 moves have been down and 19 up.

The net result? Rates are only 0.5 percentage points lower than 10 years ago. Until yesterday, the official cash rate was exactly the same as it was a decade before.

Official rates have been as high as 7.25% and as low as 3.75% over that time.

Short term rate movements give us something to talk about, but are rarely meaningful for investors with a long-term perspective (those last 6 words should be a tautology, by the way).

Excluding dividends (which dramatically handicaps the result), Woolworths (ASX: WOW) shares have doubled, BHP Billiton (ASX: BHP) has tripled and Domino's Pizza (ASX: DMP) shares have quadrupled. Add in dividends, and the story becomes even more compelling.

The devastatingly simply Foolish take-away
What should investors in those companies have done in response to each of those last 28 interest rate moves?

Precisely nothing. Or more accurately, precisely nothing different to what they should have already been doing.

That is, invest diligently, paying reasonable prices for high quality businesses with attractive (read: growing) futures. If there are attractive opportunities, take advantage of them. If not, be content to just wait.

Some of the most successful investors of our time have successfully used that approach through wars, recessions, oil shocks and the IT revolution – to devastatingly successful effect.

Very few of those have chopped and changed strategies each time a new piece of information comes to hand.

Treat this week's rate cut the same way.

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Scott Phillips is an investment analyst with The Motley Fool.  Scott owns shares in Domino's and Woolworths. You can follow him on Twitter @TMFGillaTake Stock is The Motley Fool Australia's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691).

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