Does the RBA set interest rates?

We all hear about the Reserve Bank of Australia (RBA) in media, time and time again. Are they moving rates? Dropping/raising rates, what are the banks going to do?

But what does this really mean for you the consumer? This post covers one of the most common questions we’re asked about the RBA. We’ll be covering off a few more questions in other posts too.

Does the RBA set interest rates for financial institutions?
The RBA does not set interest rates for Australian financial institutions, despite common misconceptions. The RBA sets a target for the interest rate on overnight loans between financial institutions in the wholesale money market. The wholesale money market is the market where financial institutions borrow and lend to each other.

The RBA then borrows and lends overnight money on the wholesale markets (i.e. influencing the supply of, and demand for, overnight money) to ensure the actual overnight interest rate remains as close as possible to its target rate. Other interest rates (e.g. on home loans, personal loans, term deposits etc) in the economy are influenced by this interest rate (and many other factors) to varying degrees, so that the behaviour of borrowers and lenders in the financial markets is affected by the RBA’s monetary policy.

Two other key influences on other interest rates are credit risk and tenor (term). Most interest rates have two key components, a risk free base rate plus a margin to compensate the lender for the credit risk they’re assuming (i.e. the risk that the money won’t be repaid). Overnight money, and particularly Reserve Bank funding, has low credit risk and therefore tends to form the base rate for short term interest rates.

The second key influencer on interest rates is term. For example, it is expected that a 30 year loan will have a different rate than a 1 year loan because of expectations/uncertainty about how interest rates might change over the longer term and the longer period over which the lender is exposed to credit risk. Government Bonds tend to form the risk-free base rate for longer term interest rates. These two factors will mean that the interest rate on, say, a 25 year home loan will be higher than the RBA’s official interest rate.

If you have any questions about the RBA or about interest rates feel free to leave a comment on this post and I’ll get back to you.

^Wayne – Chief Financial Officer