Most countries have a central bank whose main function is to maintain economic stability by managing the currency and interest rates, as well as issuing bank notes. In Australia, our central bank is known as the Reserve Bank of Australia (RBA).
On the first Tuesday of every month, except for January, the RBA board convenes to determine if changes should be made to the official cash rate. The results usually make headlines, even when no rate changes are made, as has been the case since the last cut on 3 August.
The official cash rate determines the RBA’s overnight loans to commercial banks. It also affects all aspects of the economy and the fortunes of borrowers. Indeed, when the rate shifts, it has a knock-on effect on the rest of the economy as it affects how much people can borrow, the actions of businesses, and the incentive to spend or save. For these reasons, the official cash rate is used as a tool to help maintain economic stability.
Why is the cash rate increased or decreased?
The Reserve Bank uses the official cash rate as a “blunt tool” to make changes to the Australian economy, according to Hans Kunnen, chief economist at Compass Economics.
When interest rates are lowered, it becomes more attractive for borrowers to take on more debt and invest because repayments are smaller. “If it’s cutting rates, it’s to get the economy going again – to help [with] jobs and investment,” Kunnen said. In contrast, raising interest rates prevents consumers from spending money freely.
According to Kunnen, when the Reserve Bank raises interest rates, it’s worried about future inflation. The RBA’s official inflation target is 2-3% on average, over time. Currently, inflation is at a record low of 1.5%.
If the RBA is keeping interest rates stable, it’s because there are equal forces keeping rates from going either way. The RBA might also be taking a “wait and see” approach in order to gather more data about where the economy is heading.
To work out how the Australian economy is performing before deciding on interest rates, the Reserve Bank considers a range of factors, including:
- the housing market
- the value of the Australian dollar
- imports and exports
- consumer confidence
- business investment
Moreover, the standard rate cut or increase is usually 25 basis points at a time, though the Reserve Bank is known to shift the cash rate by larger amounts in a month when needed.
Why is the Reserve Bank eyeing the housing market?
Over the past three years, the eastern capitals’ booming housing markets have been under the close scrutiny of the Reserve Bank. In 2016, former RBA Governor Glenn Stevens said Sydney’s house price growth needed to be assessed against the rest of the economy when making rate decisions.
The reason for this is the relationship between the cash rate, housing construction, and property prices. “When interest rates are low, more people can afford to build, which increases construction jobs,” Kunnen said. This is usually the objective of the RBA when cutting rates, as it helps boost employment.
Low interest rates also allow homeowners to borrow more money to upgrade their own homes, pushing property prices up. And it’s not just skyrocketing house prices in Sydney that should be considered, but the level of household debt as well.
“When you’ve got no money left after [paying] your mortgage, you can’t go out and spend … if debt levels are high it can prevent economic growth,” Kunnen said.
The housing market has always had an influence on the Reserve Bank’s interest rate decisions because it’s a factor of the business cycle, according to Nigel Stapledon, chief advisor at MacroPlan Dimasi.
“It’s a two-way street, [housing] has an impact on the economy, but interest rates also impact on housing,” Stapledon said. “The Reserve Bank is aware that when it cuts rates it will stimulate housing, but it’s interested in the total picture for Australia.”
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