Factors Affecting Interest Rates

Most lending institutions including banks borrow money from the Reserve Bank of Australia (RBA). When the banks lend money to you they do so at the rate (the official interest rate) at which they borrowed from the RBA, plus a margin for them to make a profit from. This margin is often around 0.80%.

The RBA meets on the first Tuesday of every month, and will do one of three things: raise the official interest rate, cut it, or keep it the same. They do this on the basis of a range of economic indicators such as housing activity, employment, inflation and the strength of the Australian economy.

Generally as these indicators go up the RBA is more likely to raise rates. If the housing market is too strong, it can cause the economy to overheat, and consequently fuel inflation. To curb housing activity the RBA may raise rates, so that fewer people can afford to buy or build houses or units, and the housing market will be dampened, and the inflation risk lowered. Strong employment growth can also fuel inflation by creating strong wages growth, and again an interest rate rise may be necessary.

Inflation can be defined as the increase in the price of goods and services which erodes the purchasing power of money. This means that a dollar will buy you less and less.
The official interest rate has a direct effect on the growth rate of inflation. The RBA generally adopts a policy of trying to keep the inflation rate between 2 and 3% annually, but this can change if there are extraordinary factors present in the global economy.

If inflation growth is seen to be too strong (such as greater than 3%) for the good of the Australian economy, then the RBA may raise interest rates to curb consumer spending and slow the economy down. Conversely, if inflation is below 2%, the RBA may raise rates to stimulate a slow economy. Rate movements are usually small, from 0.25-0.5%, with 0.25% being the most common increment for both raising and cutting rates. The RBA will often wait to see the economic effects of an interest rate rise or cut, before making further decisions on monetary policy. If the economic outlook is uncertain, the RBA may keep rates unchanged for several months.

The RBA relies on a number of economic indicators released the Australian Bureau of Statistics (ABS). A high unemployment figure generally indicates a slow economy and the RBA may cut rates, but will also look at the other indicators. A key indicator is the Consumer Price Index (CPI) which measures the change in prices of a fixed basket of goods and services that a typical consumer would purchase. The CPI is considered the benchmark for changes in inflation, and is typically quoted as a monthly percentage. If the CPI rises rapidly, an interest rate rise may be needed.

For information on mortgages go to http://www.creditworld.com.au/home-loans.html.

Summary

• Lenders raise and lower interest rates on the basis of the movement of the official interest rate the Reserve Bank of Australia (RBA) sets.
• The RBA likes to keep the annual inflation rate between 2 and 3%.
• Strong housing, employment and consumer spending can fuel inflation, and the RBA may raise interest rates to slow the economy.
• If the economy is too slow, and inflation is below 2%, the RBA may cut rates.
• The Consumer Price Index is a key economic indicator, which the RBA will look at closely when making decisions on interest rates.

Article correct at its author date: Jan 2007. Copyright Virtual Office Space, Any unauthorised reproduction of this article will be prosecuted to the full extent of the law. Credit Cards Australia.

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