INVESTOR EDUCATION – The Cash Rate Explained
The Cash Rate is a mechanism used by the Central Banks of Australia and New Zealand to control the speed and strength of their economies. Changes to the cash rates have wide reaching implications for the general public. In this article explains what the cash rate is, how it is set and how it affects you as an individual.
What The Cash Rate Means For You
The official cash rate (or OCR) is the interest rate at which the Reserve Banks charges interest on overnight loans it makes to commercial banks (CBA, Westpac, ANZ etc). The rate is moved up or down to control the speed and strength at which the economy is operating. If the Reserve Bank believes that the economy is moving too fast and inflation is high, then they will consider increasing the cash rate. Conversely, if the
economy is slowing down and unemployment is increasing then the Reserve Bank may consider lowering interest rates. The Reserve Banks job is to moderate the economy so that it neither over heats and gets out of control or slows down and goes into depression. They typically balance the unemployment rate and the inflation rate in the economy to decide the best economic policy to promote a stable economy.
(Above is RBNZ Reserve Bank Governor Wheeler and RBA Reserve Bank Governor Stevens)
Moving the cash rate ultimately effects the economy through a number of methods.
Most intuitively it effects the rate of mortgages and loans for both the general public and companies. Increasing interest rates will mean that it is now relatively more expensive to borrow money. This may deter business from borrowing from the bank and expanding their business operations or mean that buying a house may become more expensive for a potential investor. By raising the interest rate the Reserve Bank is able to influence the decisions of both business and the public and mean that their
spending habits slow down.
Equally, lowering interest rates is used to entice both business and the public to spend money. By lowering interest rates the Reserve Bank has now made it relatively cheaper for business and the public to borrow and use the money to buy things or expand their business. By taking this action the Bank is trying to simulate and support the economy to prevent it falling into a depression.
Banks base the rate which they charge for mortgages and loans on the cost at which they are able to borrow the money themselves. Accordingly, if interest rates increase it is very likely that your mortgage rate will also go up. The reason why the public is unable to borrow at the cash rate is because banks add fees/charges on top of the cash rate in order to calculate the rate at which you are able to borrow. The extra amount is to cover the credit risk of the loan, the costs of the bank and some profit for the
shareholders.
Often banks will not change their mortgage interest rates by the same amount as the
Reserve Bank changed the cash rate. This is a situation where the banks are not passing
on the full impact of the rate cut/hike. If a cut is not passed on in full it is generally
argued by the commercial banks that their costs have gone up and therefore they are
passing this cost on to the consumer in the form of higher relative mortgage rates.
However there are also instances when a rate hike is also not passed on in full as banks
may want to leave their rates lower in order to be more competitive than their
counterparts and win more market share.
Changing the cash rate also has a direct effect on your savings rate. Just as banks move
your mortgage rates when the cash rate is changed, they also move your savings rates.
It is another way the Reserve bank is able to affect the spending and investing habits
of the public. When interest rates are very low, savers don’t not receive a great deal
for the amount they have in the bank. Because of this they are more enticed to either
spend their money or buy an alternative investment (such as equities and property)
that will give them a better return. By doing this, people spend more money and this
helps the economy grow faster. Conversely, when interest rates are high putting your
money into the bank is no more attractive and therefore people are deterred from
spending. This implicitly causes the economy to slow down.