Interest rates: Who sets them, how and why?

The Reserve Bank of Australia (RBA) is our central bank who ultimately makes the call on whether interest rates move up or down. These movements greatly influence our economy and control inflation, which is very important.

What’s a central bank?

The Australian financial system has come a long way over the years. Today we simplify things by having a Reserve Bank of Australia. The RBA is our country's primary monetary authority. Other central banks that work similar to ours include the NZ Reserve Bank, the Bank of England and the USA’s Federal Reserve.

Central banks issue currency, hold banks' compulsory deposits and set interest rates. As in most first world countries, ours is independent. If PM Scott Morrison invited the RBA to lower rates to help him win the current election, he’d be stung badly. The RBA can let no short-term political objective, and no person, influence what is best for our economy.

Who are these people?

The nine member RBA board comes from business and academia. They look at inflation, economic growth, employment, home loan, building activity and consumer spending figures before they make a decision. They read up about what’s happening overseas and how it might affect Australia. Then, on the first Tuesday of each month (except January), they cut, raise or leave interest rates alone.

Controlling inflation and the role it plays

So, it’s the RBA, not the government, setting interest rates but they don’t control all of them. Just the cash rate—which determines mortgage, loan and deposit rates and controls economic activity. The RBA’s job is to keep inflation between 2-3%. Inflation is the constant rise in the level of prices where a unit of currency buys less than it did at an earlier time. If it looks like inflation will get higher, they raise rates to help slow the economy. Less people should want to borrow, economic activity should reduce, prices should follow and then, like magic, inflation flies back to its ideal place! Moving rates down should have the opposite effect.

When they’re done making their decision, the RBA sends out a message with the chosen rate and why they picked it. A few weeks later, the minutes come out. They’re often very revealing about what each board member thought and why.

Rates right now

AMP Capital, Westpac and NAB are predicting at least one cut to rates this year, possibly two as the housing downturn dampens economic growth and keeps inflation below target for longer. There is an outside chance however, that improving economic data and tax cuts regardless of who wins the federal election may put a floor under the economy, allowing the RBA to keep rates as they are. 

I make it my business to understand all this bank stuff and more, so give me a buzz, or an email, to learn about helping a client secure finance for a home, car, or something else and to prepare for any future rate rises.