What is the cash rate and how does it affect you?

Niko Iliakis

Friday 24 May 2019

There’s been an awful lot of chatter about the cash rate lately, with analysts and commentators forecasting a cut in the coming months, and perhaps a second one before the year is through.

But what would that mean for home loan rates, or anyone with a savings account? We take a look at how the cash rate works and how it affects everyday Australians.

What is the cash rate?

First of all, the cash rate reflects the market interest rate on ‘overnight’ funds. These are the funds banks lend to one another on an overnight basis to meet their daily cash needs.

But the cash rate is more than just some insider metric — it serves as a benchmark rate for everything from mortgages and savings accounts to the exchange rate, making it an important tool for managing national monetary policy.

When the RBA makes changes to the cash rate, it has knock-on effects on many of the moving parts of the economy, like spending, investment, employment and inflation.

That’s why when the economy is strong and high demand is pushing up the price of goods, the RBA might decide to raise the cash rate to slow things down a bit and make sure inflation stays within a healthy range.

If, on the other hand, the economy is weak and demand is low, the RBA might lower the cash rate to encourage spending and investment, giving the economy the boost it needs. 

What is the RBA and how does it control the cash rate?

The Reserve Bank of Australia is the country’s central bank, and it functions as the primary decision-maker when it comes to monetary policy. According to its charter, the RBA’s goal is to promote:

a) the stability of the currency of Australia
b) the maintenance of full employment in Australia
c) the economic prosperity and welfare of the people of Australia

On the first Tuesday of every month (except January), the RBA meets to discuss whether the official cash rate should be increased, decreased, or left as it is. Their decision is announced at 2:30 pm on the day of the meeting and any change to the official rate will take effect the next day.

In the lead-up to a cut, the RBA will usually set the stage a bit. It’s quite a cautious organisation, and doing anything too abrupt would be out of character. Quick decisions made without first paving the way for them is generally what happens when there’s an emergency (see, for example, the string of cuts that occurred during the financial crisis of 2008). 

What influences the RBA’s decision?

There are a number of items on the agenda when the board meets each month. Here are just some of the things it takes into account when deciding what changes to make to the cash rate, if any.

Inflation

The RBA has a flexible medium-term inflation goal of 2-3%, meaning that while inflation is allowed to fall outside this range, at least temporarily, it should remain within 2% and 3% on average. If inflation is too high, the RBA might raise the cash rate to ensure Australians retain their purchasing power.

Employment

The level of employment (and unemployment) in the country is a solid indicator of how well the economy is performing. If unemployment is on the rise, the RBA might choose to lower interest rates to stimulate spending, investment, and the creation of new jobs.

Economic growth

If economic growth has slowed or is on the way down, the RBA might lower the cash rash to bring demand back up. This typically works by reducing the incentive to save and increasing the incentive to spend and borrow. 

The international economy

Global financial conditions also feature prominently in the RBA’s deliberations. Strong economic growth overseas can mean increased demand for Australian products. But if overseas conditions are weak, or if there are tensions among our major trade partners, it could hit Australia’s economy hard.

How does the cash rate affect home loans?

The cash rate is one of the main factors that banks take into account when setting their home loan interest rates, so any increases or decreases will usually flow through to mortgage holders.

That said, it’s not the only factor, and in the case of a cut banks are by no means obligated to pass it onto their customers in full. We saw this when the board cut the cash rate by 25 basis points in 2016 and the big banks only dropped their home loan rates by 10-14 basis points.

This is likely to be the case with any upcoming cuts, especially given the fallout from the Royal Commission, which has put many of the big banks in cost recovery mode.

Nonetheless, even a small decrease in interest rates could translate to a decent reduction in your monthly home loan repayments, and thousands saved over the life of your loan. Here’s how much the average mortgage holder stands to save under cuts of various sizes*.

CutNew RateNew RepaymentMonthly SavingsYearly Savings
0.05%4.31%$1,982$12$144
0.10%4.26%$1,970$24$288
0.15%4.21%$1,958$36$432
0.20%4.16%$1,947$47$564
0.25%4.11%$1,935$59$708

*Based on a $400,000 home loan over 30 years at 4.36% average variable interest rate and LVR of 80%.

If that sounds good to you, you can be sure you’re not the only one. Lower interest rates usually mean an influx of people entering the market, as the average home loan becomes much more affordable. The resulting competition tends to drive up property prices quite a bit.

How does the cash rate affect deposits?

Savings accounts and term deposits also move in line with the cash rate, meaning that if the cash rate goes up, you can expect much more attractive returns on your savings.

Generally speaking, this might encourage people to save more than spend, but this will depend on each individuals’ circumstances, such as their income and job security.

If, on the other hand, the cash rate goes down, this will result in a decrease in interest rates on deposits. And while most banks are unlikely to pass on the full cut to their mortgage customers, you can bet they won’t hesitate to pass it onto savers.

If the RBA opts to cut the cash rate in the coming months, the interest rate environment probably won’t turn around for some time after. So if you want to get the best possible returns from your bank, locking in a term deposit now might be a good idea.

And while term deposit rates aren’t as great as they used to be, they may be the best of a bad bunch in a few months’ time. For a look at which ones offer the highest rates, be sure to check out our term deposits comparison page.

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