17th September 2008
Interest Rates – What's happening?
On Wednesday 3 September 2008, the Reserve Bank of Australia (RBA) reduced the Official Cash Rate (OCR) by 0.25 of a percentage point. This ended a rate rise cycle which began as far back as May 2002.
Since August 2007, the OCR has increased 1 percentage point and many were wondering when the rate rises over the past 12 months would stop. However, this recent reduction in the OCR has created speculation as to when another decrease will occur. There is some belief that there may even be a further 0.25 of a percentage point reduction in October or November, but the RBA has signaled that it is taking a cautious approach with monetary policy.
What is monetary policy?
Monetary policy is economic policy that is usually handled by a country's central bank (in Australia, the RBA) and is concerned with the management of the money supply (which is a measure of liquidity in the economy), interest rates and financial conditions generally as part of the bank's broad objectives of achieving high employment, sound economic growth and low inflation. It has been acknowledged by both sides of the political spectrum in Australia that the RBA should conduct monetary policy independent of the Federal Government in power at any given time.
One of the key instruments of monetary policy is the fixing of interest rates, and in particular in Australia, the OCR. This is one of the factors that determines the price of money in the economy, which in turn is one of the key determinates of economic activity.
Monetary policy is to be contrasted with fiscal policy, which focuses on issues of taxation and government expenditure, which are properly the domain of the government in power.
What is inflation?
Inflation is a sustained increase in the general level of prices over a period of time, meaning that a given amount of money buys less and less. People on fixed incomes, such as some annuities or income from fixed interest on long-term investments, suffer most when inflation is rising, unless their pensions or incomes are fully indexed to the inflation rate. This is because the purchasing power of their income falls.
On the other hand, borrowers can sometimes benefit in times of inflation because the value of the amounts borrowed correspondingly fall in value in real terms.
Interest rates play a part in the fight against inflation. By increasing the cost of money, increases in interest rates tend to slow an economy down, which flows through to a reduction in inflation.
The questions now for the RBA is - "has it done enough to make inflation come down over time?" or "is there more to be done?"
The RBA's two (2) previous easing cycles in 1996 and 2001 both began with rate cuts of 0.5 of a percentage point with continued aggressive reductions following in quick order, but recent comments from the RBA Governor indicate that the RBA will chart a more measured path this time round. This means rather than trying to reduce inflation by pushing it down quickly, the RBA's strategy will be to seek a gradual fall over a longer period.
How does this affect borrowers?
Any reductions in the OCR that are passed on to borrowers by lenders will see those borrowers on variable rates receive a benefit i.e. a reduction in their interest rate, while those borrowers on fixed rate loans will not receive a benefit i.e. their interest rates will remain unchanged, at least until the term of the fixed loan has expired.
How does this affect investors?
Any reductions in the OCR that are passed on to investors will result in those investors receiving a reduction in their returns, while those with a fixed rate of return will receive the benefit of their returns not changing.
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Head of Funds Management
t +61 3 8610 2811
Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
Read full profile here.
La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.
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