How the Reserve Bank sets interest rates

Ever wondered how the Reserve Bank of Australia gives your mortgage rate the thumbs up or down each month? Read on to find out …

Interest rates hit as high as 17 per cent during the 1980s, hovered somewhere between 7.5 and 4.6 percent during the 1990s, and currently sit at 6.25 percent. So what factors influence the "cash rate" or interest rates as we know them?

The Reserve Bank of Australia (RBA) controls monetary policy and is the body that decides the fate of interest rates. Its board meets on the first Tuesday of every month (except January) to discuss a range of economic factors and the effects they are currently having on the Australian economy, which will impact on their decision to raise, lower or leave the existing cash rate unchanged.

The RBA primarily uses interest rates to control inflation, because controlling inflation preserves the value of money. Inflation by definition generally refers to any rise in the price of goods and services. It is measured by the Consumer Price Index, which the Department of Treasury defines as: "the regular measuring of changes in the price of a basket of goods and services which are typical of purchases made by metropolitan households in eight capital cities."

The RBA's target for inflation is between 2-3 per cent per annum. If inflation rises above this level, the RBA generally moves to raise interest rates, so consumers are paying more on their mortgages and there are fewer funds to fuel inflation. Alternatively, when inflation is at the lower end of the scale, the RBA will lower rates to stimulate the economy and create more consumer spending which will then lift the inflation rate.

Also of concern to the RBA is the performance of the overall economy and the labour market. Wages and employment have a particular influence. When unemployment is low, workers will demand higher wages, which businesses then pass on to consumers in the form of higher prices, which in turn increases inflation.

At the end of each monthly board meeting, the RBA releases a comprehensive statement to the public via its website - www.rba.gov.au - outlining the specific reasons for its decision, if any, on interest rates for that particular month.

While there are literally hundreds of factors that RBA considers, there are some general domestic and international factors that will affect interest rates. These include:

International
General international interest rates and world economic growth
Inflation in the US
Level of $AUD
Oil prices

Within Australia
Inflation
Wages and employment
Exports
Consumer credit
Investment markets
General increases in wealth

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