To understand how our economy works, you don’t need a Masters in Economics but you must be familiar with the role of the Reserve Bank of Australia (RBA). Like its peers in other countries — European Central Bank, Bank of England and the US Federal Reserve, for example — the RBA is Australia’s primary monetary authority. To state the obvious, interest rates; which influence mortgage, loan and deposit rates and control economic activity, are set by the RBA — not government. Dropping rates makes borrowing money cheaper, stimulating demand and investment. Raising them does the opposite.

The RBA formulates and implements monetary policy which involves setting the interest rate on overnight loans in the money market. This influences other interest rates in the economy, which influences the behaviour of borrowers and lenders.

But what influences RBA decisions on interest rates?

1. Inflation

Inflation refers to an increase in the general price of goods and services. In Australia, inflation is measured by the quarterly Consumer Price Index (CPI). The Australian Bureau of Statistics monitors the CPI by looking at price changes in a ‘basket’ of typical goods and services — e.g. milk, butter, clothes and education — over time.

One of the RBA’s mandates is to keep annual inflation between 2% and 3% and its tool of choice is interest rates using monetary policy which has proven quite effective until recent years. The idea is that if rates go up less people borrow money, causing slower economic activity, weaker price growth and reduced inflation. If interest rates go down, things happen in reverse.

The RBA’s uses monetary policy to:

Since the early 1990s, the RBA’s remit has been to keep inflation between 2–3% p.a. to foster strong, sustainable growth. This preserves the value of our currency and promotes long-term growth.

2. Employment

When interest rates are lowered, the economy is stimulated and borrowing is easier and more affordable. Businesses can afford loans to expand and this creates more jobs. With more people employed, there is more spending and investment, and this leads to even more employment. A virtuous cycle of prosperity. So, the RBA may choose to lower interest rates if unemployment is high or rising.

Monetary policy (see above) influences inflation and our demand for goods and services and, therefore, the demand for jobs for people who make or provide them. It does this mainly through its influence on the finances of households and businesses. 

3. Global events

RBA decisions on interest rates are also impacted by events overseas:

The AUD

When the Australian dollar (AUD) is high relative to the USA’s dollar (USD), our exports are more expensive and it’s harder to sell goods and services overseas. If the RBA decreases interest rates, Australia becomes a less attractive place for foreign investors who can make better returns elsewhere. Less interest in the AUD reduces its market value, making our exports cheaper. The opposite is also true. Key factors influencing demand for the AUD are:

Generally, higher rates increase the demand for and value of a currency because foreign investors can earn higher interest rates. And vice versa. However, this is complicated by a host of other factors. Firstly, there’s the interrelationship between higher rates and inflation. If the RBA can successfully raise rates without raising inflation, then the value and exchange rate for the AUD will likely rise to. And secondly, there’s an adage in economics that goes – if you want to know what’s going to happen to interest rates, have a look at the global trend

Conflicts

From the Gulf war to 9-11, global conflicts impact the world economy in many negative ways. Fear, uncertainty and doubt take over, as nations employ a variety of policies in their scramble to encourage trade or reinstate global order. Interest rates can be raised to encourage international money into Australia or dropped to stimulate the domestic economy and fire up exports.

Economic shocks

The GFC was an economic shock that provided a shining example of how interest rates can cushion the economy. At the start of the panic, the RBA quickly lowered rates from 7.25% to 3%. Other shocks include Brexit and the outcomes of various elections that are set to have a material influence on the global economy.

Needless to say, changing interest rates heavily affects the residential housing market. Beyond price they shape the availability of capital to borrow/lend which shapes supply and demand which shapes prices. Given how much of our money is tied up in residential housing — particularly in Melbourne and Sydney — developments in the residential market also widely impact things like RBA decisions, economic growth forecasts and employment rates and in some circumstances, the future direction of separate housing markets as investors scour the nation for yield.


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