Interest rates are arguably the most important issue facing Australian homeowners.
However there is much confusion about who controls interest rates, what factors influence rates and how this affects mortgage repayments.
Does Wayne Swan control interest rates?
No Wayne Swan does not control interest rates. Nor does Tony Abbott.
So who does?
The cash interest rate is decided by the Reserve Bank of Australia (RBA). The RBA are an independent government department with the mandate to control monetary policy.
The RBA’s board meets 11 times a year to discuss and make announcements on monetary policy and the cash interest rate.
What is monetary policy?
Monetary policy is the process by which central banks (like the RBA) control the stability of a country’s economy. They have various levers that they can pull, that can speed up or slow down the economy, one of the major levers is interest rates.
The speed of the economy can be measured in a number of ways, one of the key measures is the prices that we pay for goods and services. This is measured four times a year in something called the Consumer Price Index (CPI). The CPI is the key measure of inflation.
When the price of goods in the CPI goes up, inflation goes up, and wages are then increased as people demand more money from their employers to pay for the things they need, like food and petrol.
To make up for the increased wages, companies often increase their prices and this creates further upward pressure on inflation. If inflation is not controlled the value of money becomes lower and lower as prices become higher and higher until eventually people can no longer afford to buy anything and economic activity grinds to a halt.
The aim of monetary policy is to control inflation, to keep the economy growing slowly but steadily. If inflation is too high, the RBA increases rates, to deter consumer spending and slow inflation.
But what about when the economy slows down?
Good question. The global financial crisis has impacted world markets on a scale not seen since the Great Depression in the 1930’s. There were strong signs that the world’s major economies were hurt as a result.
While the US and Europe felt the full force of the GFC, Australia emerged in better shape, however there was some slowing down of the local economy. This prompted the RBA to cut rates strongly. The aim of doing this was to stimulate spending and therefore protect the economy from a sharp downturn. We are starting to see signs now of rate rises, due to the recovering economy.
How does that affect my mortgage repayments?
The RBA cash rate is based on the rates paid by banks in the wholesale market. So while credit is available to banks at a rate of, say, 6.5 percent in the wholesale market, they will add a premium before applying the rate to retail loans and mortgages. The concept is the same as a supermarket buying produce in bulk at a lower rate than offered to shoppers.
If the RBA cuts rates, then the banks follow, reducing the interest rates they charge their customers.
However this situation is complicated by the fact that Australian banks have to go offshore to seek funding for their (or your) debts. This is because there are not enough savings in Australia to finance the debts.
In 2009 this pattern had been out-of-whack as wholesale market credit costs had been increased by the global credit crisis. This was because banks became fearful of lending money to each other, so the costs of borrowing skyrocketed.
How can I tell if rates will rise or fall in the future?
Unless you’ve got a fully-functional crystal ball, it’s hard to know absolutely which direction rates are headed.
However, the interest rate futures market can give some hints. Investors buy interest rate futures to protect themselves against rate movements in the future. As a result, if 90 day interest rate futures (usually described as “dealers bill rates”) is at seven percent and today’s cash rate is 6.5 percent, the futures market thinks rates will be around seven percent in three months.
So who controls interest rates?
No one person or organisation is in sole charge the direction of interest rates. Indeed, while the RBA sets the rate, the factors that influence it are spread far and wide.