If you have a mortgage, or are saving to buy a property, chances are you have heard about the Reserve Bank of Australia's (RBA) official cash rate.
That's because the cash rate can affect the interest rate on your mortgage, it can affect how much interest your savings might earn and on a broader scale, it's tied up with inflation, jobs and the general health of the economy.
Every month except January, the RBA board meets to decide on the most appropriate monetary policy for Australia’s economic environment. The policy involves setting the cash rate, which is the interest rate banks charge each other on overnight loans.
Banks lend money to other banks each day to manage daily cash needs. Given that these are loans for the shortest term, they are known as “overnight” funds and the interest rate charged is an overnight rate.
The cash rate is generally the lowest interest rate at which banks borrow from each other and it serves as a benchmark rate in the country.
The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation, the RBA explains on its website.
From an individual’s point of view, it is important to keep up to date on the movement of interest rates to get a clearer picture of how this might affect your finances.
Interest rate movements can be a catalyst to review your savings, investments, mortgages and other debts to potentially change your financial position.
Loans and mortgages
In deciding the interest rates charged to borrowers, banks take into account many factors, including the cash rate, the risk that the loan might not be paid back, the necessary margins to generate return for shareholders, and competition from rivals.
A higher cash rate can have a flow-on effect that lifts interest rates on credit card, loan and mortgage repayments, leaving consumers with less available income to save or spend.
Knowing that if the cash rates rises, those debt repayments can go up, too, might discourage people who don't already have a loan or a mortgage from doing so.
“When the RBA raises the cash rate, generally it is because they want to put the brakes on demand growth and the rate of inflation. Higher interest rates tend to act as a restraint on lending growth, which has a negative impact on demand and inflation,” says Gareth Aird, senior economist at Commonwealth Bank.
“If the cash rate falls, the RBA is trying to boost economic activity and inflation by encouraging consumer spending and business investment – lower interest rates encourage businesses and households to borrow rather than save which lifts economic activity,” he says.
For property owners with a mortgage, lower interest rates could reduce their repayments and result in more disposable income. The lower cost of borrowing money might also encourage people to take out loans to purchase properties.
Savings and investments
When the RBA increases the cash rate, interest rates on deposits usually rise as well. Theoretically, that can encourage people to save rather than spend.
“In that case, people who put their money in savings accounts or term deposits get higher rates of return,” Aird says.
Conversely, when interest rates decrease, it becomes less appealing to save money, he adds.
However, it should be noted that the level of interest rates doesn’t necessarily change saving habits. Other factors are also important and each individual has different circumstances that will affect their personal financial decision making process.
Things to be considered include your view on whether you think your income might change in the future, your employment and job market prospects and your overall perception of the current economic conditions.
Buying bonds is another way to invest. In the fixed income market, prices of bonds move in the opposite direction to interest rates.
When interest rates rise, the capital value of your existing bonds is likely to fall due to weaker demand because bonds with lower coupon (interest) rates are less appealing than new bonds issued at higher coupon rates.
From a cash rate decision perspective, fluctuations in the exchange rate are important because they affect the prices of imports and exports.
If the value of the Australian dollar falls against other currencies, then imports become more expensive in Australian dollar terms and exports become cheaper.
This will generally have a positive impact in terms of economic activity, but can also lead to inflation, which is when prices rise.
Given the cash rate decision is made by the RBA in the context of trying to keep inflation within a certain band, currently a target range of 2% to 3%, to support healthy growth in the economy, Australia's exchange rate is a very important factor.
When interest rates increase in a particular country, foreign investors may be more attracted to invest there. This is because the potential returns available on assets that earn interest have increased.
This in turn will boost demand for the currency of that country, as foreign investors look to acquire local currency in order to buy local assets. This tends to strengthen the exchange rate, which in turn can help to restrain inflation.
Inflation, or the rate at which the cost of living is changing, concerns every consumer as long as you use goods and services.
Apart from managing growth in the nation’s economy, the RBA uses the cash rate to maintain price stability.
Changes in the cash rate affect the likelihood of businesses and households obtaining funding. Higher interest rates make it more expensive to borrow money and can typically reduce demand for goods and services, thus preventing substantial price increase.
“Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term,” the RBA says on its website.
The relationship between the exchange rate, inflation and the cash rate is quite complex. Cash rate movements become important to consumers and businesses because how the cash rate moves can affect lending and borrowing activities, the value of the AUD, inflation and economic growth.
The information in this article is true as at May 2016.