Interest Rates 101

How (and why) does the Reserve Bank control interest rates, and what does it mean for your home loan, bank deposits and other investments?

While we understand banks charge interest on their home loans, exactly what determines the rate? Following recent rate rises, should we be worried that interest rates will spike even higher in the years ahead?

For most people, it’s all a bit of a puzzle.

Traditionally, the Reserve Bank of Australia (RBA) is tasked with the responsibility of setting interest rates. It does this at monthly board meetings by determining the so-called cash rate, or the price the big retail banks pay to borrow money in the overnight cash markets.

This is part of a complex mechanism the Reserve Bank uses to control the level of cash or liquidity in the banking system. Doing so directly impacts the rate of interest charged by banks, not just on home loans but also on every product they sell.

This is a critical lever the Reserve Bank uses to regulate economic activity.

For example, suppose the economy is slowing. In that case, the RBA can lower the cash rate, increase liquidity throughout the banking system and, in doing so, encourage the big banks to reduce rates. This in turn lowers costs for businesses and typical households with debt, encouraging spending and economic activity.

If the economy is trading too strongly, as indicated by a sharp upturn in property prices or a jump in the inflation rate, the RBA can use the cash rate to reduce liquidity, increase interest rates, and slow activity.

The decision to change the cash rate is announced following the RBA’s monthly board meetings.

Regulating the economy is as much an art as it is a science, with market analysts studying the RBA’s monthly board meeting minutes to gain a sense of the bank’s attitude toward interest rates.

In the minutes released following the April 2022 cash rate hike, the RBA said it had considered raising the cash rate by between 0.15 per cent and by 0.4 per cent but had finally decided on an increase of 0.25 per cent (from its low point of 0.1 per cent).

To emphasise this point, in a press conference following this rate rise, the Reserve Bank boss of the time, Phil Lowe, noted it ‘was not unreasonable to expect’ the cash rate to climb as high as 2.5 per cent in the near future. Indeed, a further 0.5 per cent increase followed in June and the same again in July, resulting in a cash rate of 1.35 per cent.

However, just the talk of higher interest rates can achieve the desired impact on economic activity. And this in itself can reduce the need for rate increases and, with that, lower how high rates need to rise. The situation is complex.

Many Australians are highly geared; they have taken out substantial home loans believing record low interest rates would remain for years. Therefore, even a small rate hike can significantly impact the cost of their mortgage.

The COVID-19 pandemic encouraged Australians to save, with Market Economics estimating an extra $50 billion was contributed to home loans during this time. On average, home buyers were then 45 months ahead on their repayments.

While this was good news, it would then deaden the impact of any RBA rate rise as home buyers could effectively use the equity built up in their home loans to offset the higher bank charges.

Such factors make the RBA’s task of moderating economic activity through cash rate adjustments even more challenging.

As discussed further in our Investment Update article, it’s important to remember the RBA is trying to moderate the economy, not kill it. Interest rate rises are generally a sign that the economy is going well, and our current low unemployment would attest to that. Consider also that some of our current inflation is due to outside factors such as the war in Ukraine, fuel prices, and flood-affected food supplies, rather than an overheated economy.

So in terms of practical action, here are some tips:

  • As a borrower, always make sure you have some backup, such as emergency buffer funds in offset or redraw, and review whether there are expenses you can trim back if needed.
  • Don’t count on your bank showing you loyalty – contact a mortgage broker here at AGS to check whether your current rates are still competitive and consider refinancing
  • As a deposit holder, be aware there can be vast differences in the rates offered between different banks, and for different deposit periods. At AGS we can easily compare and place term deposits with different institutions, with a minimum of admin hassle and without needing to go into a bank branch.
  • For investors, keep your long-term focus and don’t forget the time-honoured basics. While an interest rate rise often sparks a pull-back in share & property values, these periods often serve as a buying opportunity that most only regret not taking action on.

As always, if you need any advice or assistance with your mortgage, deposits or investment strategy, please contact us

Published : 11 Jul 2022

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