What are interest rates?
On the first Tuesday of every month (except for January), the Reserve Bank of Australia meets to discuss whether to change or keep the current ‘cash rate’, which is kind of like interest rate, but not in the way you might know it. Guess what? Today is the first Tuesday of the month. If you’re struggling to understand it all, and how it might affect you, we’re going to give you all the tools to become fluent in all that economics chat.
Let’s start with some definitions:
What is the Reserve Bank of Australia (RBA)?
It’s not actually a bank like the Commonwealth Bank or NAB. It’s an institution that is responsible for the stability of our currency (AUD) and a thriving economy. The way they do this is through monetary policy, like adjusting the cash rate (remember this term).
What is an interest rate?
A percentage of a loaned amount of money that a lender will charge the borrower. Interest rates are required every time money is lent from one person to another, whether that’s the RBA to banks or banks to consumers.
The current interest rate is 0.10%. That means if you were to borrow $100 at this interest rate, you would have to pay the bank back $100.10.
The interest rate hierarchy
There are lots of different interest rates. Let's think of it as a hierarchy, as they have a flow-on effect on each other.
Top of the hierarchy: The cash rate
This is the rate (plus 0.25%) that banks can borrow from the RBA. This is what is decided on the first Tuesday of every month by the RBA. The RBA either lowers, raises, or keeps the same cash rate. The cash rate dictates how much money banks have to offer consumers in loans. If the cash rate goes down, banks will borrow more from the RBA. If the cash rate goes up, banks will borrow less from the RBA. Cash rates are like a control stick for the economy.
Bottom of the hierarchy: Consumer loan interest rate (for things like mortgages)
Whatever happens to the cash rate (explained above), directly affects the interest rates on loans that people like you and me would get. If consumer banks have borrowed more from the RBA because of a low cash rate, they are able to give consumer loans at a lower interest rate to encourage people and businesses to buy more. But if the cash rate has been raised by the RBA, then the banks will borrow less, meaning they will have to increase the interest rate on the consumer loans, making loans more unattractive.
What is the purpose of the RBA making those changes?
Remember the control stick analogy we gave before? The RBA makes these changes through these means to keep inflation under control. The inflation sweet spot is around 2-3%.
Lowering cash rate = incentivises spending over saving
RBA encourages banks to borrow more from the RBA, to then give consumers loans with attractive lower interest rates. To keep the economy healthy, it’s wanting consumers to buy more.
Raising cash rate = incentivises saving overspending
The RBA wants to slow things down and control inflation because there is too much money in the economy. Raising cash rates will make borrowing money more expensive, and less attractive for both banks and consumers.
Remaining the same = RBA is happy with how the economy is tracking
The RBA believes that the current rates are encouraging inflation to settle at (or remain) 2-3%, and the economy is healthy.