Interest rates are the cost of money when borrowed or loaned, and are used to control inflation and economic growth. But why do interest rates rise and fall, and how can they affect you?
Who controls interest rates?
Movements in official interest rates are determined by the RBA. Their objective is to ensure that price growth (inflation) remains low and stable and it uses ‘monetary policy’ to do this. Monetary policy involves either increasing the cost of money (interest rates) to slow the economy down, or lowering the cost of money to encourage spending which promotes economic growth.
The official cash rate
One of the ways the RBA manages rate of growth of the economy is by making changes to the interest rate it charges financial institutions, commonly referred to as the ‘official cash rate’. This cash rate feeds through to financial products which have variable interest rates, such as savings accounts, cash management trusts, variable rate mortgages and personal loans. It also impacts cost of funding for the banks.
Consumer Price Index (CPI)
The RBA monitors inflation through the Consumer Price Index (CPI) which measures price changes on a basket of goods and services that a typical consumer would buy. A rise in inflation can lead to a rise in interest rates. While low inflation can allow the RBA to lower interest rates. The RBA targets inflation to be between 2% and 3% over the economic cycle. If inflation is towards the top end of this band or above it and rising, this is a signal that the RBA may lift the official cash rate. While if inflation is at the low end of this band and other indicators such as growth and employment are weaker, this could signal the RBA may cut the official cash rate.