Why RBA Increases Cash Rate And How Does It Affect You

The Reserve Bank of Australia (RBA) plays a pivotal role in shaping the nation’s economic landscape. Among its various policy tools, the cash rate is a powerful instrument that has significant implications for the broader economy and individual households. In this article, we will delve into the reasons why RBA increases the cash rate and explore how these decisions can impact you, as a citizen, investor, or borrower.

Understanding the Cash Rate

Before we dissect the reasons behind the RBA’s cash rate adjustments, it’s essential to understand what this rate represents. The cash rate is the interest rate at which banks lend to and borrow from each other on an overnight basis. It is considered the benchmark for interest rates across the entire economy, affecting everything from home loans to savings accounts.

Why RBA Increases Cash Rate

The RBA primarily increases the cash rate for two key reasons: inflation control and financial stability.

1. Inflation Control

One of the primary objectives of the RBA is to maintain price stability, which is defined as keeping inflation within a target range of 2-3%. Inflation is the rate at which the general price level of goods and services rises, leading to a decrease in the purchasing power of money. When inflation is too high or too low, it can be detrimental to the economy.

When inflation is persistently above the target range, it erodes the real value of money, reducing the purchasing power of households and impacting their standard of living. This can lead to a vicious cycle of increasing wages and prices, making it difficult for households to plan for the future.

Conversely, when inflation is too low or negative (deflation), it can result in reduced consumer spending and business investment. In a deflationary environment, individuals and businesses tend to delay purchases, expecting prices to fall further. This can lead to lower economic growth and increased unemployment.

Hence, the RBA increases the cash rate to cool down the economy when inflation is rising too rapidly. By making borrowing more expensive, they aim to reduce consumer spending and slow down economic growth, ultimately curbing inflation.

2. Financial Stability

In addition to managing inflation, the RBA is responsible for promoting financial stability. This entails ensuring that the financial system is resilient and can withstand economic shocks. When asset bubbles form, such as in the housing market, they can pose a risk to financial stability.

An asset bubble occurs when the prices of assets, like houses or stocks, become detached from their intrinsic value and rise excessively. This can be driven by speculative behavior and excessive lending by banks. Bubbles are unsustainable, and when they burst, they can lead to significant economic downturns, as seen in the global financial crisis of 2008.

To prevent asset bubbles from forming, the RBA may increase the cash rate. Higher interest rates discourage excessive borrowing and speculation in the housing market, which can cool down the property market and reduce the risk of a housing bubble.

How an Increase in the Cash Rate Affects You

Now that we’ve discussed why the RBA increases the cash rate, let’s explore how these decisions can affect you as an individual, investor, or borrower.

1. Mortgage Holders

For most homeowners, a mortgage is the most significant financial commitment. When the RBA increases the cash rate, it leads to higher interest rates on home loans. If you have a variable-rate mortgage, your monthly repayments will increase, making homeownership more expensive.

While this can put pressure on household budgets, it’s important to remember that the RBA typically raises interest rates to combat inflation. If left unchecked, high inflation can erode your purchasing power even more over the long term. In this sense, an increase in the cash rate aims to protect the value of your money.

2. Savers

On the flip side, an increase in the cash rate benefits savers. If you have money in a savings account or term deposit, you’ll earn higher interest on your savings. This can be a welcome change if you’ve been earning minimal interest on your savings in a low-rate environment.

However, the impact on savers can be somewhat limited since savings account interest rates tend to move more slowly than the cash rate. Nevertheless, when the cash rate is increased, you should expect to see improved returns on your savings over time.

3. Investors

Investors often have diversified portfolios that include various assets like stocks, bonds, and real estate. An increase in the cash rate can have mixed effects on different parts of your investment portfolio.

A. Stocks: Higher interest rates can lead to reduced consumer spending, which can negatively impact corporate profits. Consequently, stock prices may experience some downward pressure, particularly in sectors that are sensitive to interest rates, such as utilities and real estate investment trusts (REITs).

B. Bonds: When interest rates rise, the value of existing bonds falls, as they offer lower yields compared to new bonds issued with higher interest rates. If you hold bonds, this can result in a temporary decline in the value of your bond portfolio. However, as your existing bonds mature, you can reinvest in higher-yielding bonds.

C. Real Estate: An increase in the cash rate can lead to higher borrowing costs for property investors. This may reduce demand for investment properties and put downward pressure on property prices in some markets.

4. Businesses and Consumers

Higher interest rates can impact businesses and consumers in various ways:

A. Businesses: Increased borrowing costs can lead to reduced investment by businesses, which can slow down economic growth. Businesses with variable-rate loans may experience higher interest expenses, affecting their profitability.

B. Consumers: Beyond mortgage holders, higher interest rates can affect all consumers who have loans with variable interest rates, such as personal loans and credit card debt. These loans become more expensive to service, increasing the financial burden on borrowers.

Conclusion

The RBA’s decision to increase the cash rate is a complex process driven by the need to control inflation and maintain financial stability.

While these decisions can have both positive and negative consequences for individuals, investors, and businesses, it’s important to recognize that they are made with the broader economic well-being in mind. By understanding the reasons behind these cash rate increases and how they affect you, you can make more informed financial decisions and adapt to changing economic conditions.