Why do banks decide to increase or decrease interest rates and who influences their decision? This article explains as simply as possible what drives interest rates.
The Reserve Bank of Australia (RBA) and the major trading banks may play the most visible role in setting interest rates, but in many cases, they are being reactive rather than proactive.
A wide range of external factors feed into their decision-making process, including in no small part, our collective behaviour as investors and savers, borrowers, and consumers. Then there’s the rate of inflation and wages growth, foreign currency exchange, the economic health of our trading partners, and the interest rates paid by local banks to borrow money from overseas.
Suddenly it’s not so easy to figure out where interest rates are headed, even in the short term.
A fine balance
To look at just one part of the puzzle: the RBA dropped the cash rate to 0.10% in November 20201, the lowest rate on record, and a rate which remained unchanged for the following 16 months. This has made it cheaper for businesses to borrow and invest in job-creating activities. However, mortgage rates also followed the cash rate down, allowing homebuyers and investors to borrow more, which subsequently also drove up house prices.
So how can the RBA keep a lid on housing costs without choking business activity and consumer spending?
One way is to get by with a little help from its friends, in this case, the banking regulator, the Australian Prudential Regulation Authority (APRA). APRA can impose a range of restrictions on the banks. These include capping new interest-only lending and limiting the growth in lending to investors. Lenders can also be ordered to keep a tight rein on ‘risky’ loans, for example, where loans exceed 80% of the value of the property.
While APRA’s main motive is to make the banks more resilient to any shocks such as another global financial crisis and the economic slowdown caused by the COVID-19 pandemic, a side effect is that the banks will have to reduce the amount they lend for housing. And according to the rule of supply and demand, if less money is available then the cost of that money – the interest rate – will go up.
Benchmarking
Interest rates in Australia are also affected by the Bank Bill Swap Rate (BBSW). This is calculated by the ASX at the same time every day and is based on the rates being bid and offered by approved trading institutions on short-term interest-bearing securities. General interest rates are set by financial institutions in reference to the BBSW.
Navigating uncertain waters
Appreciating the complexity of interest rates doesn’t always help in deciding how to respond to them. Even the experts often get it wrong when trying to predict where interest rates are going. This doesn’t help answer borrowers’ eternal question: “do I lock in a fixed rate, or opt for a variable rate?”
Harley Dale, chief economist at CreditorWatch, cited several key developments that influenced the RBA’s March 2022 decision to hold rates. “The Ukrainian crisis provides substantial geopolitical uncertainty. Consumer confidence has already been trending down for nearly 12 months and supply chain issues associated with the crisis is likely to lead to a higher demand in groceries, sparked interest rates and steeper mortgage repayments.”, Mr Dale said2.
Not sure what to do? If your mortgage is due for a review or you’re looking to invest or buy, talk to us, your licensed financial planner, or mortgage broker to get a professional opinion.
The information contained in this article is general information only. It is not intended to be a recommendation, offer, advice or invitation to purchase, sell or otherwise deal in securities or other investments. Before making any decision in respect to a financial product, you should seek advice from an appropriately qualified professional. We believe that the information contained in this document is accurate. However, we are not specifically licensed to provide tax or legal advice and any information that may relate to you should be confirmed with your tax or legal adviser.
- https://www.rba.gov.au/statistics/cash-rate/ ↩︎
- https://www.investordaily.com.au/regulation/50875-rba-makes-interest-rate-call ↩︎
