On the first Tuesday of each month (apart from in January) the Reserve Bank of Australia (RBA) meets to discuss and announce the cash rate decision.
This blog discusses what the cash rate is, why the RBA may decide to increase or lower it and the implications of these changes to you as a property investor.
The RBA's stated goal is to oversee monetary policy in Australia to achieve its objectives of:
To support these objectives, the RBA has agreed that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2 to 3 per cent, on average, over time.
According to the RBA, this is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community.
The cash rate is the ‘instrument’ used to influence inflation in order to achieve this flexible medium-term target.
Source: RBA Website
The cash rate is the interest rate charged on overnight loans in the money market.
Or, put simply, it is the amount of interest a commercial bank must pay the Reserve Bank if it takes out an overnight loan.
For example, if Westpac decided to borrow $50 from the RBA, with the cash rate at its current rate of 1.5 per cent, it would have to pay the RBA $1.50 per year for the privilege.
The transmission of monetary policy refers to how a change to the cash rate, whether it is increased or lowered, affects the interest rates that households and businesses face and so therefore economic activity, employment and inflation.
This diagram is a simple representation of the transmission of monetary policy.
When the RBA decides to lower the cash rate, this causes other interest rates in the economy to fall.
It is the RBA's intention that the lower interest rates will stimulate spending within the Australian economy.
Businesses would then increase how much they produce, leading to an increase in further economic activity and therefore employment. If the increase in demand is high enough, it can push up prices and lead to higher inflation.
When deciding on interest rates being charged to borrowers, banks will take into account many factors, including:
So the cash rate can also have a strong influence on the lending behaviour of the banks and the propensity of consumers to apply for mortgages.
For example, one mechanism a bank can use to stimulate people to apply for mortgages is to offer a lower variable interest rate.
If the RBA lowers the cash rate, the banks will decide whether they will reflect the drop in the variable interest rates available on their home loans.
Often there will be commentary after a cash rate reduction, where you will hear discussion from analysts and even politicians, on whether banks will decide to "pass on" the rate cut in full or not.
In a free market, banks are free to decide how they respond to a cash rate cut and are under no obligation to drop the interest rates they charge on their mortgages.
But similarly, a bank must also take into account how it is perceived by the public. For example, if the public sees that the cash rate has dropped, but the interest rate on their mortgage has stayed the same, they’re not going to be particularly happy!
The RBA Board meets on the first Tuesday of each month at 2.30pm, apart from in January, to discuss and announce the cash rate decision.
There are three options. It can decrease, increase, or stay on hold.
When making the cash rate decision, the RBA will take many factors into account, including:
The RBA is likely to keep the cash rate on hold when inflation is within the board’s target level and the economy is growing at a sustainable rate.
If the RBA wants to stimulate the economy, essentially encouraging us to spend more money, it may cut the cash rate.
If you have a variable home loan rate and your lender passes on the rate cut, you’ll enjoy a noticeable reduction in the amount of interest you have to repay towards your loan.
If you have a mortgage of $500,000, a 0.25 per cent interest rate cut could result in you saving approximately $80 per month, assuming a starting interest rate of 4.25 per cent over a loan period of 25 years.
However, if you’re locked into a fixed rate loan, you’ll have to wait until the fixed rate period ends before you can take advantage of lower rates.
When the fixed period is up, you may wish to negotiate a better rate or see if another lender might be willing to offer you a more attractive deal.
Another effect of a cash rate decrease is that more people are likely to enter the property market.
As lower interest rates means home loans become more affordable, home buyers and property investors could experience increased competition in the real estate market.
This competition and increased demand could then in turn drive property prices prices up.
When the RBA believes the the economy is overheating, it can increase the cash rate in an attempt to control consumer spending, which in turn would slow the rate of inflation.
From a property investor's point of view, it is important you keep abreast of the movement of the cash rate, so you know how it could affect the rates you pay on your loans and also the impact it can have on the economy in general.
At MRD, we send out an email to our blog subscribers each month as soon as the cash rate is announced.