Interest rate basics

Andrew Pegler – 15 October 2010

With so much talk about interest rates I thought it apt to take a look at some of the basics of the whole shebang.

What’s a central bank?

This is a country’s primary monetary authority. Ours is called the Reserve Bank of Australia, known as the RBA. Other examples include the European Central Bank, the Bank of England and the Federal Reserve in the US. Central banks are busy bees. They issue currency, hold banks’ compulsory deposits and, most importantly for our purposes, set interest rates. Like most rich countries ours is independent of politics so it can’t be dictated to by the PM or anyone else. That way we usually get what is best for the economy, not short-term political objectives like lowering rates during an election campaign.

Who are these people?!

The nine members of the RBA board come from business and academia the board’s only women is Jillian Broadbent AO. They meet on the first Tuesday of every month to work though a few cups of tea and decide to cut, raise or leave rates as is. They do this after taking a good look at the latest inflation figures, economic growth, employment, home loans, building activity and how much people are spending on consumer goods. They also look at what’s going on overseas and how that will affect us. The board members are very smart, they get out a lot.

This is in your interest

As I said, the RBA is our central bank and it – not the government – sets interest rates. There are a few different kinds of interest rates but the one we’re dealing with is called the cash-rate, which is the one that influences mortgage, loan and deposit rates. The RBA uses interest rates to control economic activity. It raises them to keep the inflation genie square in its bottle and drops them to stimulate demand and investment. The principle is that if rates are higher then less people will want to borrow money and therefore economic activity will slow and that means prices slow and that means inflation slows. And vice versa. When they’ve done deciding our fate the RBA sends out a press release outlining the new rate, and why. A few weeks later they release the minutes of the meeting, which are often very revealing about what individual members of the RBA board thought and why.

Hopefully that clears that up.