How are interest rates set?

Understanding property finance 👉16

We hope you are finding this Wealth Through Property series informative?
Today we are covering another important aspect of property finance which is understanding how interest rates are set!

Understanding interest rates should be an essential part of every property investor’s (and indeed, every Australian’s) education. After all, they have a huge effect on not only an investor’s portfolio and finances, but how our country’s economy works.

Just a couple of decades ago, interest rates were set by the government. The Reserve Bank of Australia (RBA) lends money to banks, which then lend money to consumers. The RBA lends money at a variable rate to banks, and the banks pass this rate on with a markup to make some money in the process.

The problem with public servants and the government controlling the interest rate was that they could use it to their political advantage. After all, the interest collected by the RBA is revenue for the government that is then used to pay for their expenses and promises. So parties would ramp up interest rates when they had bills to pay, which, as you can imagine, was not healthy for the economy.

During the recession in the 90s, then-Prime Minister, Paul Keating decided to make the RBA independent, by setting an independent board to govern it with the following duties and goals:

• To stabilise the currency of Australia,
• To help maintain employment levels; and
• Ensure the economic prosperity and welfare of Australians.

The ideal inflation rate was identified as 2-3% per year on average to ensure these targets were met. The RBA board is able to influence inflation rates by adjusting the interest rates.

Here’s how:

• Each month, they check the prices of key indicators – from the price of milk to the price of petrol, and everything in between.
• Price trends are noted to see what inflation is doing.
• If it appears that inflation is going up significantly, the RBA board will increase the interest rate.
• In turn, the banks will increase their lending rate, which will result in homeowners and property investors having less money to spend, reducing pressure on inflation.
• The opposite will happen if inflation is decreasing significantly. The RBA will drop the interest rates, leading to banks dropping their lending rate, and anyone with a mortgage will find they have more money to spend, which will help inflation level out again.

Thus, the RBA helps to stimulate or de-stimulate the economy as needed.

You’ll have to admit that it’s a pretty brilliant system, which is evidenced by how well we did even through the Global Financial Crisis. When the crisis hit Australia, the RBA board dropped interest rates by about 4.5% in just 6 months, a move which helped to keep the economy stable when the rest of the world was in turmoil.

Stay tuned for more daily insights from Wealth Through Property.

~Daimien Patterson
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