Why does the RBA change the interest rates and how important is it really?
Written by Will Lucas
We often hear plenty of news about what the Reserve Bank of Australia (RBA) is expected to do to interest rates and how they’re either the devil coming to punish us all or the hero coming to save the day. Often the whole operation is incredibly politicised but why is this system in place and what does it aim to achieve?
The Reserve Bank of Australia (RBA) plays a central role in the Australian economy, and one of its most influential tools is the cash rate. Understanding the cash rate and the RBA’s decision-making process is crucial for anyone looking to gain insight into Australia’s economic health and how various financial factors can impact their daily lives. From mortgage payments to savings interest rates, the cash rate is at the heart of many financial decisions.
What is the Cash Rate?
The cash rate, also known as the official interest rate, is the interest rate at which commercial banks borrow and lend money to each other. Essentially, it is the benchmark for the interest rates set by banks and other financial institutions across Australia. This rate is set by the Reserve Bank of Australia (RBA) during its regular meetings of the Monetary Policy Board.
While the cash rate might seem like a technical term used by economists and financial experts, it is a tool that has far-reaching consequences for everyone, from businesses to households, investors, and borrowers. When the RBA adjusts the cash rate, it sets the tone for how much it costs to borrow money in the economy and how much savers will earn on their deposits.
Why Does the RBA Set the Cash Rate?
The RBA determines the cash rate as part of its monetary policy, which aims to maintain economic stability and ensure a sustainable level of growth. The primary objectives of monetary policy are:
Price Stability: The RBA aims to keep inflation, the general increase in prices of goods and services, within a target range of 2-3%. Inflation that is too high can erode purchasing power, while inflation that is too low can signal a stagnating economy. By adjusting the cash rate, the RBA can influence inflation levels.
Full Employment: The RBA also aims to maintain full employment, which refers to a situation where everyone who is willing and able to work can find a job. This is critical to the health of the economy as it supports income levels and consumption. There is also concern that if unemployment falls too much (meaning nearly every working Australian has a job at all times) then this can fuel concerning levels of inflation. If you’re interested in this, check out the NAIRU.
Economic Growth: The RBA’s ultimate goal is to foster economic growth that is stable and sustainable. By adjusting the cash rate, the RBA can encourage or discourage borrowing, which can impact business investment, consumer spending, and economic expansion.
The RBA sets the cash rate with these goals in mind, using it as a lever to influence the overall level of demand and spending in the economy. When inflation is too high, the RBA may raise the cash rate to cool down spending, and when the economy is sluggish, the RBA may lower the rate to encourage borrowing and investment.
How Does the Cash Rate Affect the Economy?
Here’s a breakdown of how changes to the cash rate influence various economic factors:
1. Why raise the cash rate?
To reduce inflation
The cash rate directly affects the interest rates that commercial banks charge individuals and businesses. When the RBA raises the cash rate, banks typically follow suit and increase their lending rates. This makes borrowing more expensive, as people and businesses will face higher interest payments on loans and credit.For individuals, this can mean higher mortgage rates, more expensive car loans, and higher interest payments on credit cards. As a result, the average Australian is less likely to have spare cash to buy a new TV, go out for dinner, or take a holiday up the coast! The same can be said for businesses who are less likely to invest in new projects and have less revenue coming through from their customers.
At the same time, savings rates people can receive will increase encouraging them to keep their hard-earned cash in the bank instead of spending it. These two factors combined aim to reduce spending within the economy overall to hamper inflation and economic growth.
2. Why lower the cash rate?
To encourage economic growth and higher levels of employment
A lower cash rate reduces the cost of borrowing for both individuals and businesses. If borrowing money from a bank will cost less, business are more likely to invest in new projects, expand their operations, or hire more workers. This investment drives economic growth and productivity while creating more jobs.
For individuals, cheaper borrowing means Australians are more likely to take out a loan to spend some money and those with an existing mortgage will have lowered repayments and therefore more cash each month to spend on goods and services.
How the Cash Rate Affects Australians: Real-Life Examples
The effects of changes to the cash rate are felt across different segments of the population in varying ways. Let’s explore a few real-life examples to understand the impact:
1. Mortgage Holders
For homeowners with variable-rate mortgages, the cash rate directly affects their monthly repayments. When the RBA cuts the cash rate, mortgage holders may see a decrease in their interest rate, resulting in lower monthly repayments and more disposable income. Conversely, an increase in the cash rate can lead to higher repayments, putting a strain on household budgets. We saw the effect of this with those who purchased homes during the Covid era of 2% mortgage rates and have had these rates triple in the space of a few years, putting strain on householders (but reducing inflation in the meantime).
2. Savers and Retirees
Savers and retirees who depend on interest income from savings accounts, term deposits, and other investments can be impacted by changes in the cash rate. When the cash rate falls, interest rates on savings accounts also tend to decrease, which means retirees who rely on interest income for their living expenses may experience a reduction in their income. This is why it’s important to have retirement assets invested in other assets that may benefit when interest rates fall as well (it’s all about balance!).
3. Investors
Investors are also affected by changes in the cash rate. Lower interest rates can encourage more investment in the stock market, as people seek higher returns than those offered by savings accounts. On the other hand, higher interest rates may encourage more conservative investment choices, such as bonds or term deposits.
4. Businesses
Small businesses that rely on loans for expansion or operations may be directly impacted by changes in the cash rate. A lower cash rate makes loans more affordable, encouraging businesses to invest in growth. However, a higher cash rate may deter investment and lead to reduced business activity.
The RBA's Vital Role in Shaping Australia's Economy
The RBA’s determination of the cash rate is a crucial part of the country’s economy, ensuring that inflation and unemployment remain manageable. While it’d be great to always have a steady rate of economic growth and never have to change interest rates, the world is never this kind.
The cash rate impacts every Australian in some way—whether it’s through higher or lower mortgage payments, changes in savings interest rates, or shifts in consumer spending and investment. Understanding how the cash rate works and how it influences the economy can help to make more informed financial decisions, whether they are managing household budgets, planning for retirement, or running a business.
The cash rate is not just an abstract number determined by the RBA, but it does have a massive impact on our day-to-day lives. Our advice; always expect the worst and hope for the best to ensure that life will go on and these changes don’t thwart your plans.
Click here to book a 15-minute Good Fit Chat
The information in this article is general information and does not take into account any person’s individual situation. You should always do your own research, or seek professional advice to assist you in making an informed decision about what suits your needs.