Why the RBA cares about house prices and how it affects interest rates

The majority of countries in the world have a central bank whose role is to maintain economic stability by managing the currency and interest rates, and issuing bank notes.

In Australia, this institution is known as the Reserve Bank of Australia, also referred to as the RBA or the Reserve Bank.

On the first Tuesday of every month, except for January, the RBA board meets to determine whether it should change the official cash rate. The result usually makes headlines – even when it chooses not to change the rate at all – as has been the case since a cut in August 2016.

But what does this mean for you? And should you be concerned about an increase in rates? Domain spoke to the experts to answer your questions about this critical part of Australia’s economy.

What is the cash rate?

When someone talks about the “cash rate” they’re really talking about the “official cash rate”. This is the rate at which the RBA provides overnight loans to commercial banks and setting this rate is one of the Reserve’s most critical functions. 

When this rate changes, it has a knock-on effect to the rest of the economy as it affects how much people can borrow, the incentives to spend or to save and the actions of businesses. For this reason, it’s a tool used to help maintain stability in the economy.

Currently, the rate is 1.5 per cent – a record low.

Why does the RBA increase or decrease the cash rate?

The interest rate is a “blunt tool” used by the Reserve Bank to make changes in the Australian economy, the chief economist at Compass Economics, Hans Kunnen, said.

Lowering interest rates makes it more attractive to take on more debt and invest, because repayments on this amount are smaller.

“If it’s cutting rates, it’s to get the economy going again – to help jobs and investment,” Mr Kunnen said. 

On the other hand, raising interest rates restricts consumers from spending more as they’re usually spending more money on paying off their debt.

“If [the RBA is] raising interest rates, it is worried about inflation into the future,” Mr Kunnen said. The RBA’s official inflation target is 2 to 3 per cent “on average, over time”.  Currently, inflation is low – at about 1.5 per cent.

If the RBA is keeping interest rates stable, it’s because there are equal forces pushing either way or the RBA is taking a “wait and see” approach to gather more data about where the economy is heading.

To work out how the Australian economy is performing to make this decision the RBA considers a range of factors, including:

• The housing market
• GDP
• Inflation
• Unemployment
• The value of the Australian dollar
• Business investment
• Retail performance
• Imports and exports
• The global economy
• Consumer confidence

Source: Finder

The standard rate cut or increase is 25 basis points at a time, but the RBA has been known to shift the cash rate by larger amounts in a month when needed.

Why has the housing market become such a big focus?

During the past three years, the housing market – particularly in Sydney – has been a focus of the Reserve Bank.

In 2016, even then RBA governor Glenn Stevens admitted Sydney’s house price growth caused him some discomfort and needed to be weighed up against the rest of the economy when making rate decisions.

The reason for this is the clear relationship between the cash rate, housing construction and property prices, Mr Kunnen said.

“When interest rates are low, more people can afford to build, which increases construction jobs,” he said. This is usually an ideal outcome for the RBA when cutting rates, as it helps boost employment.

Low interest rates don’t just allow people to borrow more to buy and build new properties  – they can afford to spend more on established homes as well as a “side effect”. This pushes prices up, he said.

But it’s not just the specific price of a Sydney house but the level of household debt that should be considered. Or, how much people are taking on in the form of mortgages.

“When you’ve got no money left after your mortgage, you can’t go out and spend … if debt levels are high it can prevent economic growth,” Mr Kunnen said.

Considering the Reserve Bank’s decisions over the long-term, it’s clear the housing market has always had an influence because it’s a factor of the business cycle, MacropPlan Dimasi chief adviser Nigel Stapledon said.

“It’s a two-way street, [housing] has an impact on the economy, but interest rates also impact on housing,” Dr Stapledon said.

“The Reserve Bank is aware that when it cuts rates it will stimulate housing, but it’s interested in the total picture for Australia.”

The latest price boom in eastern capital cities, in particular Sydney, has largely been driven by the “fundamentals” – fewer homes were built for several years, high rates of immigration and higher rents.

When you add lower interest rates to the mix, you have the “ingredients for a house price boom,” he said.

While a degree of the surge can be explained by lower rates, housing markets tend to develop their “own momentum” whereby expectations of growth lead to higher prices being paid.

“The longer these booms go on, the greater the risk they might overshoot,” he said.

How does this affect me?

For those who aren’t in the housing market, it can seem as though the changes in interest rates are irrelevant to their everyday life.

However, all Australians are directly or indirectly affected by the RBA’s decisions.

If you’re a “saver” with money in the bank, you will tend to find the interest rate on your savings declining when the official cash rate is dropped. This concerns retirees and first-home buyers in particular, as well as those who have additional funds sitting in a savings account as a cash investment.

“If the RBA reduces interest rates, people are forced to look at non-cash investments,” Mr Kunnen said. These non-cash investments include the sharemarket, and the housing market – meaning those who can afford to buy are more likely to jump into an investment property. 

This can cause prices to rise, leading to an even more difficult situation for first-time buyers, he said.

But if you’re a home owner, this can have the direct opposite impact – you pay less each month in your mortgage repayment.

Rising interest rates have an opposite effect – savers are better off, but those repaying loans on a variable rate will find the cost of holding on to debt rising.

It’s also worth noting that lenders have been increasingly out of step with the official cash rate since 2008, at times increasing their standard variable rates even when the RBA has not changed rates.

What will the RBA do next?

After months of interest rates being on hold, it’s unlikely we’ll see a change any time soon, comparison website Finder‘s insights manager Graham Cooke said.

“With GDP figures somewhat recovering from a bad quarter and wage growth slow, the RBA may be cautious to disrupt these gentle improvements,” Mr Cooke said.

“On the other hand, a surging housing market driven by Sydney and Melbourne is making property less and less affordable for first time buyers,” he said.

This has left the RBA walking a “thin line”, but it is likely to continue to wait.

On Finder’s Reserve Bank survey, 90 per cent of economists anticipate out-of-cycle rate increases in the future from banks as they look to increase capital.

All 38 experts surveyed expected the RBA would keep rates on hold this month.