Interest rates affect us all, whether it’s the interest we are paid on our savings (accumulating interest in our favour) or our mortgage repayments (in the bank favour), it impacts millions of Australians daily. So, who and what influences the interest rate and why does it change?
Who is responsible for interest rates?
For the Reserve bank of Australia (RBA) to fulfil its charter, as detailed in the Reserve Bank Act 1959, the bank is required to control domestic interest rates, which will help contribute to:
- stability of the currency of Australia and maintenance of full employment
- economic prosperity and welfare of the people of Australia.
The RBA has concluded that the best way to meet these objectives is to keep inflation between 2% to 3%.
Why do interest rates change?
In simplistic terms, the RBA controls official interest rates to make the borrowing rates cheaper to all businesses and consumers, thereby reducing expenses and increasing spending/demand. This increase in demand may increase inflation, as suppliers of goods and services may be able to increase their prices, lifting the inflation to within the banks desired inflation target range, which is 2% – 3%. Lower interest rates are associated with a lower Australian dollar too, as foreign investors look elsewhere for higher returns in other markets. In what some term is a race to the bottom, a lower dollar makes our manufactured goods cheaper to foreign buyers, boosting our exports and tourism (when it returns) to this country.
In contrast, increasing rates have the opposite effect, they increase the cost of borrowing, discouraging both borrowing and spending, thereby decreasing inflation pressures in the economy, often resulting in a higher Australian dollar, and reduced competitiveness of our exports and the attractiveness of Australia as a tourist destination.
Keep in mind, while the RBA is looking to fulfill its charter, not all central banks are focussed on inflation rather their currency and their ability to attract foreign investment.
Why is my home loan rate higher than the cash rate?
The RBA’s cash rate provides a level of interest rates in the wholesale market that is used by the banks. The banks access this credit in the wholesale market (along with consumer savings) and add a premium before they apply an interest rate to consumer loans and mortgages. This approach also applies for Small Business Enterprise business lending too.
A good analogy is a supermarket, which buys goods from wholesalers at a lower price, adds a margin and provides the products to consumers. This is how banks make their money.
For more information on how to develop a better investment strategy in the current low interest rate environment or discuss your lending, contact us or give us a call at FWD Financial on 0410 FWD FWD (0410 393 393).