Each month we wait and hear if the Reserve Bank will increase or decrease interest rates. While a lot is written on the effects of a rise or fall, the reasons behind rate movements are rarely discussed.
Setting interest rates is a complex process and to describe all elements of influence would take pages…and leave you in a spin. Here’s a brief summary of some key factors that should help you to understand why interest rates are increased or decreased.
Rate rises indicates a healthy, growing economy. The Reserve Bank looks at a number of economic indicators including employment, inflation and business activity. If these are favourable [ie: low unemployment and high growth] the Reserve Bank believe people are likely to spend more.
Increased spending stimulates a range of economic indicators, including inflation. To minimise inflation the Reserve Bank must encourage people to save money. An effective way to achieve this is to slow down spending by increasing interest rates.
As deposit interest rates also increase, people without a mortgage are encouraged to spend less by putting their money into savings. People with a mortgage are forced to spend less, as they must put any extra cash into their mortgage.
When people have less money to spend because of higher interest rates, there is more competition among sellers of goods and services which increases price competition and puts downward pressure on inflation.
A time of stability. The Reserve Bank does consider the economy moving in the desired band in regard to growth and inflation, hence there is a hold on the current interest rate. This has been the prevalent circumstances for over 18 months now, hence providing great stability in the market.
When economic factors point to a slowdown or a downturn in the economy (increased unemployment, lower inflation) the Reserve Bank may reduce interest rates. This strategy aims to increase spending, helping businesses to survive, employ more staff, encouraging the economy to grow. Usually, the band of inflation that is targeted (around 4%), compared to the actual, provides a good indicator of what will happen in the long run.