Interest rates: how, when, who and why

Interest rates are a major talking point for Australians and rightly so: after all a mortgage is often the biggest financial responsibility facing families.

However, despite their importance, there remains some confusion over how rates are set, what influences them and what doesn’t.

Who’s at the wheel?

In terms of actually setting the cash rate (the base interest rate) the Reserve Bank of Australia (RBA) is in the driving seat. Its overriding aims are to ensure the dollar remains stable, promote full employment and contribute to the economic prosperity of Australians.

The bank looks to achieve these aims by keeping consumer price inflation with a two to three percent range. This is broadly in line with the inflation targets of Australia’s peer economies.

If the Australian economy is a car the Reserve Bank is driving and interest rates are the pedal it uses to keep the car at a steady speed. Too slow and the bank may lower rates to encourage growth, too quick and a rate hike might be used to douse the economy’s enthusiasm.

For example in the second part of 2008 as the world teetered on the edge of financial meltdown, the RBA worried that the Australian economy would slide into recession. It responded by slashing interest rates through 2008 and 2009.

This gave people more disposable income, protected them against mortgage defaults in the event of losing their jobs and as a result stimulated economic activity.

But as the economy has recovered, rates rose again, in part to ensure the inflation remained under control and to avoid creating asset bubbles fuelled by cheap credit.

How does the RBA decide?

The RBA’s board meets 11 times a year to discuss interest rates. The board comprises academics, economists and senior businesspeople.

Detailed reports on the Australian and international economy are prepared for the board. The reports might include information on retail sales, consumer confidence, the prices paid by producers and more. It also looks at international markets, the price of wholesale credit (bank to bank) the performance of the Australian dollar and other issues.

Globally, rates tend to move in cycles and often take their lead from the US, the world’s biggest economy. For example, a comparison of US and Australian interest rate movements in the past 10 years reveals similar trends in terms of rises and cuts, until 2008 that is.

Why is my loan interest higher than the cash rate?

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, 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.

Australians are not net savers – as a nation, our debts are bigger than our savings – so the banks have to source wholesale funding for lending from overseas banks. Because of the financial crisis, this funding has become more expensive. Some analysts dispute this, suggesting that the margins earned by banks over the past few years show that banks costs have not increased by as much as they claim.

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 five percent and today’s cash rate is 4 percent, the futures market thinks rates will be around 5 percent in three months.

Economists also make interest rate forecasts and these are often reported in the media. There can be a wide divergence of views among analysts about what direction rates will take and many were caught off guard by the rapidity of the financial crisis and the sudden change in rates direction.

So who is in control of rates?

No one person or organisation is in sole charge of the direction of interest rates. Indeed, while the RBA sets the rate, the factors that influence it are spread far and wide. That said, the rate you pay on your mortgage or personal loan is determined by the retail banks.

Posted by NineMSN Money on 16th January, 2011