22 Feb 2011

RBA: Friend or Foe?

The Reserve Bank of Australia (RBA) plays a key role in the management of our economy and regularly makes headlines in the press. Have you ever wondered exactly what its role is and how it makes decisions which impact all Australians and significantly mortgage holders?

Reserve Bank of Australia (RBA)

The RBA is Australia’s central bank and is accountable to the Australian Parliament for the stability of Australia’s financial system. The bank is an active participant in financial markets, manages Australia’s foreign reserves, issues Australian currency notes and serves as banker to the Australian Government.

The primary responsibility of the RBA is to maintain a strong financial system by monitoring the supply, availability and cost of money (ie monetary policy).

The RBA’s charter states that decisions must be made that will best contribute to:

  • the stability of the currency of Australia,
  • the maintenance of full employment in Australia, and
  • the economic prosperity and welfare of the people of Australia.

How does the RBA meet its charter?

Since 1993, the RBA has had the objective of keeping the inflation rate between 2% and 3%. The key benefit of low inflation over the long term to Australia’s economy is to:

  • assist businesses in making sound investment decisions, underpin the creation of jobs,
  • protect the savings of Australians, and
  • preserve the value of the currency.

The RBA’s target inflation rate is defined as a medium term average rather than a set rate that must be held at all times. This recognises that there are always uncertainties in forecasting and also takes into account any lags in the effects of monetary policy on the economy.

Role of the cash rate

The Reserve Bank fulfils its role of maintaining a stable financial system by setting the cash rate. The RBA’s measure of the cash rate is the interest rate which banks pay or charge to borrow funds from, or lend funds to, other banks on an overnight unsecured basis. This measure is also known as the interbank overnight rate. The cash rate is the primary influence over other interest rates.

How does the RBA set the cash rate?

The RBA Board meets each month (with the exception of January) to look at a number of economic indicators in order to determine if a change to the cash rate is required. Some of the indicators it looks at are:

  • current inflation rate,
  • current level of unemployment,
  • Consumer Price Index,
  • health of the retail sector, and
  • world economy.

If required, the cash rate is then adjusted according to the forecasted inflation rate. If the inflation rate is forecast to rise, the cash rate is likely to be increased to slow the economy. If the inflation forecast is low then the cash rate is likely to either hold or be reduced to provide short term stimulus to the economy.

Link between the cash rate and mortgage interest rates

As the cash rate forms a baseline for the rates that are paid by borrowers across the market, it is crucial to home loans and consumer credit because a change in the cash rate is typically transmitted directly and immediately to variable rate loans.

Variable rate loans are the most common group of loans written for home mortgages in Australia. Fixed rate home loans and personal loan interest rates are also impacted by changes in the cash rate, although to a lesser extent.

So as much as we never like to hear that the RBA has increased the cash rate again (because we know that this will hit all mortgage holders directly in the hip pocket), it is taking the necessary steps to ensure a strong, stable economy in Australia for the long term.

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