Rising interest rates have caused many to start educating themselves on how the RBA cash rate works, and how it’s used to fight inflation.
If you are one of those people, you have come to the right place.
What is the RBA Cash Rate?
The RBA cash rate (also called the cash rate target) is – put simply – Australia’s “official interest rate.”
Referred to as a conventional monetary policy tool, it is the (near) risk-free benchmark rate (RFR) for the Australian dollar, which banks use to lend each other money in a “short term money market.”
In this short term money market, the RBA cash rate is also referred to as AONIA (AUD Overnight Index Average) as it is the reference rate for Australian dollar overnight indexed swaps (OIS) and the ASX’s 30-day interbank cash rate futures contract.
What is a risk-free benchmark?
In finance, a risk-free benchmark serves as a reference point or baseline for determining what the appropriate interest rates or returns in financial transactions are.
This type of investment or security (such as a government or treasury bond) carries a negligible risk of default or loss, which is why financially stable countries use government debt as this benchmark, as they are unlikely to default.
How does the RBA cash rate work?
The RBA cash rate target is based on an “inflation targeting framework“, aiming to keep inflation in the range of 2-3% on average over time.
Inflation is the annual percentage change in the cost of goods and services from one year to another, measured by the quarterly release of Consumer Price Index (CPI) data from the Australian Bureau of Statistics (ABS).
In simple terms, this means the RBA changes the cash rate target to make sure that life doesn’t get more than 2-3% more expensive every year (on average, over time). Rather than choosing a specific target of 2 or 3%, the RBA aims to achieve this range “on average over time” so that prices don’t increase by more than the economy can reasonably handle, while allowing for some flexibility in inflation.
What is the purpose of the RBA cash rate?
Guided by the Statement on the Conduct of Monetary Policy, and legislated under The Reserve Bank Act 1959, banks and other creditors use the cash rate target as a guide for setting interest rates on debt.
Think of it this way, if a bank has to pay interest to borrow money from another bank, they’ll want to charge enough interest on the loans they provide, to cover the cost of that debt.
How does the RBA cash rate influence interest rates?
Each month at the RBA cash rate meeting, board members discuss international and domestic economic outlooks and raise points as to whether they should increase, pause or decrease the cash rate target.
As the benchmark or RFR used by banks and other financial institutions to set interest rates on financial products, the RBA cash rate has a significant influence over interest rates.
Interest (earned from savings) is the amount you are paid (as the creditor) for placing your money in a savings account, that banks then use to make loans (debt) for borrowers.
When the RBA Cash Rate target changes, banks, financial institutions and ADIs (Authorised Deposit-taking Institutions) adjust their current rates in response. This can either stimulate, or contract, the economy, depending on the current economic conditions and the direction of the change.
However, it is important to note that as well as the RBA cash rate, market competition, default risk, funding costs and various other factors also influence how end-user interest rates are set.
How does increasing the cash rate reduce inflation?
The RBA can fight periods of high inflation by raising the cash rate target.
When the cash rate target increases, interest rates on credit cards, home loans, personal loans and coupon rates on corporate bonds and fixed income investments, will generally rise in response.
In fact, the recent hiking cycle from the RBA could see Australians paying up to $15,000 more in mortgage repayments in 2023, as thousands of fixed rate mortgages (as low as 2%) reach maturity and switch over to variable rate mortgages.
Whilst this does sound damaging to the economy (and mortgagee’s bank accounts), increasing interest rates is an effective way for the RBA to stifle inflation, and contract the economy, when prices are getting out of hand.
By making debt more expensive, at a time when the cost of living (inflation) is already high, the RBA is encouraging consumers reduce their spending and remove liquidity from the economy.
As RBA Governor Philip Lowe says, ” High inflation makes life difficult for people and damages the functioning of the economy.”
“If high inflation were to become entrenched in people’s expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment.”
What happens when the cash rate decreases?
The RBA typically reduces the cash rate when they need to stimulate economic activity and increase GDP growth. When the cash rate decreases, the cost of borrowing money gets cheaper, as you pay less interest to borrow the same amount.
This makes borrowing money (debt) more attractive and stimulates demand and growth. A clear example of what happens when the cash rate target decreases can be seen in the COVID-19 period of “free money lending,” where the cash rate target sat at 0.1% from November 2020 to May 2022.
Near-zero and negative cash rates, combined with COVID19 policy responses, saw huge injections of liquidity (major deposits of money) into advanced economies in 2020-2021, as money became almost free to borrow, in addition to savings accounts no longer offering attractive returns.
The impact of the RBA cash rate on fixed income investors
As the RBA cash rate increases, so do the coupon rates on newly issued bonds and fixed income securities. A high RBA cash rate allows fixed income investors to take advantage of higher-than-average yields, as well as the passivity and predictability of income that these lower-risk investments provide.
The cash rate also influences the price of bonds.
When the cash rate increases, bond prices go down, providing an opportunity for savvy investors to secure capital gains, on top of regular coupon (interest) payments. If you buy a fixed income investment or bond for lower than face value, and hold it until maturity, the original face value will be returned, despite the price you paid for it.
For example, if you invest $100,000 in a fixed income security or bond, with a face value of $100 and a bond price of $97, you can have opportunity to recoup an additional $3,000 ($3 x 1,000) at the maturity date.
Why are interest rates going up in 2023?
Central banks in Australia, the UK, US, and in Europe are all hiking their respective “official interest rates” in 2023 to fight the global battle against inflation.
Though each central bank has slightly different terms for the rates used as the (near) risk-free benchmarks within their own regions, they all operate in a similar fashion in that they influence the cost of borrowing money.
In the US, the Federal Reserve has a target range for their cash rate, rather than a fixed figure, and is called the Federal Funds Rate.
When does the RBA board review the cash rate?
The RBA cash rate is reviewed on the first Tuesday of every month (except for January) by the RBA Monetary Policy board, with decisions released here.
The RBA board is currently composed of nine members, including the Governor, Deputy Governor and Deputy Chair, however a recent review by Treasurer Jim Chalmers could see the RBA board implement a dual board in the near future.
- Economic growth, measured by Gross Domestic Product (GDP)
- The cost of living, and whether prices are rising due to cost-push or demand-pull inflation
- Housing, and whether the market is tight or soft, by reviewing occupancy, costs and migration
- Employment and unemployment figures, including underemployment and job mobility
- The cost of labour, including annual increases in award wages and the national minimum wage
By reviewing key economic data, the RBA can see whether they need to increase supply or demand and change the cash rate target accordingly.
Data accurate as at 4.7.2023
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