The interest rate in simple terms is the cost of borrowing money. It is the amount a lender charges a borrower and is a percentage of the principal—(the total loan amount).
The cash rate is the interest rate that banks pay to borrow funds from other banks in the money market overnight.
The Reserve Bank of Australia (RBA) manages the rate of growth of the economy by making changes to the interest rate it charges financial institutions, commonly referred to as the ‘official cash rate’. Changes to the cash rate impact financial products which have variable interest rates, such as savings accounts, variable rate mortgages and personal loans as well as the cost of funding for the banks.
The RBA controls monetary policy by adjusting the official cash rate based on economic indicators including employment, inflation, economic growth, the consumer and the housing market.
If the economy is growing too fast it can lead to high inflation, while weak economic growth can lead to unemployment, reduced incomes and lower living standards.
The objective of the RBA is to ensure that price growth (inflation) remains low and stable and it uses ‘monetary policy’ as a lever or a tool to achieve this. Monetary policy involves either increasing the cost of money (interest rates) to slow the economy down, or lowering the cost of money to encourage spending which promotes economic growth.
Currently, inflation is high, and therefore the objective of their monetary policy is to raise the interest rates to slow things down.
The RBA’s function is very important as an increase in unemployment generally points to a slowing economy, which may lead the RBA to cut rates to encourage consumer spending and growth. On the other hand, strong growth in employment can fuel inflation by creating wages growth, in which case an interest rate rise may be necessary, to stop the economy overheating.
Global outlook
The RBA also looks at important international factors that will drive the performance of the Australian economy, in particular the demand for and the price of Australia’s natural resources. If Australia’s trading partners are growing strongly and demand and prices of raw materials are rising, this can lead to strong economic growth in Australia and place upward pressure on interest rates. While if commodity prices and demand for our natural resources falls, this could point to slower growth and be a case to lower interest rates.
The broader global economic outlook is also considered given the important transmission to Australia through consumer and business confidence, the share market and broader economic activity. The global outlook can be impacted by a number of factors, including sovereign debt concerns, global interest rate moves and natural disasters.
The RBA monitors inflation through the Consumer Price Index (CPI) which measures price changes on a basket of goods and services that a typical consumer would buy. A rise in inflation can lead to a rise in interest rates. While low inflation can allow the RBA to lower interest rates. The RBA targets inflation to be between 2% and 3% over the economic cycle. If inflation is towards the top end of this or above it and rising, this is a signal that the RBA may lift the official cash rate. While if inflation is at the low end of this band and other indicators such as growth and employment are weaker, this could signal the RBA may cut the official cash rate.
The RBA meets 11 times a year on the first Tuesday of each month, except in January. When they meet, they will raise the official cash rate, reduce it, or keep it the same. For the official cash rate, please visit www.rba.gov.au.
For many Australians, a rise in interest rates will mean increased repayments on mortgages, loans and credit cards. Remember, rising interest rates usually signal rising inflation, which means cost of living is higher, and this may have significant impact on your monthly outgoings and any major financial decisions.
When interest rates are lower, it may be a good opportunity to get in front with your savings and your mortgage if your budget allows.
While mortgage brokers and lenders always assess your borrowing capacity at a higher rate than the current interest rate, it makes sense for you to make your own decisions based on how interest rates are tracking and build in a buffer that you are comfortable with.
All lending subject to status and lenders criteria. Terms & conditions apply. This document contains general information only. Your own personal circumstances have not been considered and you should seek independent financial advice prior to making any decision on a financial product.
