Interest rate rises: what you need to know

By Karina Barrymore, News Limited newspapers, 14 September 2009

CHRISTMAS certainly won't come early this year. Anything but. Most experts are tipping an official interest rate rise before Santa does his rounds.

So just why are interest rates going up again? What makes rates rise and fall? Who makes the decision? Who benefits? And, why now, in Australia, when other countries show no sign of lifting their rates?

Let’s start with that last question. Why now?

The good news is that Australia is weathering the global downturn really well. It is the only major developed country to record economic growth last financial year.

Aussie households and companies are still spending and expanding despite the financial crisis and recession in other countries.

"Aussies just want to have fun," Commsec chief economist Craig James says. The spending figures show consumers are buying up big on games, toys and hobbies.

However, buying new cars, gambling and visits to the doctor have taken a hit, he says. ‘‘It makes a lot of sense.

"The global financial crisis was on in earnest over the past year and Australians were keen to forget all about it," James says.

The spend-now attitude has been encouraged by the Federal Government’s $60 billion stimulus package of cash handouts. Unfortunately all that fun has a downside.

There is concern that spending and economic growth will get out of control, inflation will start up again and interest rates will rise.

Australia will have to pay for its above-par performance, James says.

So what do interest rates do?

High interest rates suck up any spare money sitting around that people might be tempted to spend.

Households, businesses and companies are then too burdened with their high debt repayments to have any money left over for items considered unnecessary or for further expansion.

Low interest rates mean households and companies have some spare money in the kitty to spend because they are paying less to make their debt repayments.

When people spend a lot, prices increase, which causes inflation to go up.

When people don’t have money to spend, prices and inflation can go down or at least stay steady. Who sets these interest rates?

Each night all banks must balance their books. However, it’s impossible to physically get all the cash back in the vault each night so they "borrow" the shortfall from the Reserve Bank of Australia.

In turn, the RBA charges them its official cash interest rate for "lending" them the money overnight.

So the RBA sets the official or cash rate that it charges all the other banks and that is why this rate gets passed on to everyone, through the system.

Why do interest rates go up?

The RBA uses interest rates to control inflation. Ideally the RBA wants inflation to be between 2 and 3 per cent, which it believes is the right level for the normal forces of supply and demand.

When economic growth – spending and expansion – is in danger of going up too fast, the RBA increases interest rates to reduce spending and to slow down growth in the economy.

When the economy looks like it might slow down too much, the RBA cuts rates, to free up or create some spare money and keep spending ticking along.

The RBA board members meet each month to discuss a whole range of economic factors before deciding what it will do about interest rates.

Its guiding measure, however, is inflation. However, these decisions are made in advance of the growth or the slowdown actually taking place so RBA board members must constantly estimate what will or won’t happen in the future.

Who makes the decisions?

Just like most marketplaces, anyone can decide how much they want to charge for their goods or services.

The RBA is Australia’s central bank so it decides how much interest it will charge the other banks.

In turn, those banks pass on that interest rate – including a profit margin – to their customers.

Separate to what the RBA does, banks and lenders can also increase or reduce their interest rates at any time they like.

Like any other business, this decision is based on what they think their customers can bear and what their competitors are charging, according to Consumer Action Law Centre director Nicole Rich.

Until recently the private banks and lenders stuck with the RBA, lifting and cutting interest rates in line with the central bank. But during the past year or so they have increased their interest rates independently.

"These days banks get wholesale funding from a range of sources. "The cost of their funding can go up or down even if the official Reserve Bank cash rate doesn’t change," Rich says.

"People need to be aware that banks could put up their interest rates even before the Reserve Bank makes any decision," she says.

Who benefits?

Higher interest rates usually mean a higher return for anyone with cash on deposit. However, some banks have lifted their borrowing rates but have not increased their deposit rates.

Generally, however, it means deposits earn more.

"A rate rise is a bonus for self-funded retirees as earnings from cash and fixed interest investments will increase," Hewison & Associates private client adviser Glenn Fairbairn says. ‘‘It is also a greater incentive for people to save,’’ he says.

High interest rates also push up the value of a country’s currency.

The Australian dollar has climbed almost 30 per cent against the US dollar during the past six months because of expectations interest rates here will increase.

Because of Australia’s strong economy, it is expected to be one of the first countries to increase interest rates.

When will rates rise?

Just when rates will rise again in this cycle is a hot topic of debate. Some forecasters have tipped as early as next month, others don’t expect a move until next year.

According to Herald Sun economic commentator Terry McCrann, it would take something dramatic for the RBA to lift rates as early as October.

But the longer it holds off, the more likely the individual banks will increase rates independently, he says.

"If they could be confident the RBA would hike in October or even November, they would wait – aiming to slip in, say, a 35-40 point hike on the back of an official 25-point move," McCrann says.

"But if the clock ticks by and there’s no official hike, who will be first?"