A simple look at complex interest rates

Interest rate settings are a key factor in economic activity, including the performance of Australia’s housing market.

Higher interest rates reduce affordability, slowing down housing activity and creating pent-up demand. Lower rates improve affordability, releasing pent-up demand.

It is this demand – driven by high levels of immigration, a housing shortage and Australians’ strong emotional attachment to home ownership and property investment – that underpins the robustness of the housing market.

It also means that the interest rate cycle and house price growth are closely linked: falling interest rates drive up prices; rising rates drive down prices.

Cost of borrowing

Interest rate settings are a key macroeconomic policy tool. The RBA determines the rate settings and monetary policy at its monthly meeting, where it sets the cash rate that determines the cost of borrowing and indirectly how much is earned from money on deposit.

It increases interest rates when it wants to slow down price growth, controlling inflation. Increasing rates raises the cost of borrowing, which reduces demand in the economy. If the RBA wants to stimulate weak economic activity, it reduces rates to increase demand.

The RBA takes several factors into account when it’s setting the cash rate, including inflation, pay rises, the unemployment rate, jobs growth, the strength of the Australian dollar, gross domestic product (GDP) and house prices.

Moderating pay rises

Wages growth is important to the RBA when it’s setting official interest rate policy. Strong competition for labour in a robust economy can lead to a wages/price spiral that feeds on itself. Raising interest rates in this scenario aims to slow down the economy and moderate pay rises.

Unemployment levels are also very important when setting rates. Higher and rising unemployment is a drag on overall economic activity. By lowering interest rates and borrowing costs, the RBA is trying to increase demand for labour and reduce unemployment.

Both variable and fixed mortgage rates are essentially determined by the level of the official cash rate. The banks keep a close eye on the RBA and when it raises the cash rate, your mortgage is likely to go up. When there is a rate cut, your mortgage rate will usually fall.