What is the rate?

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Interest rates are one of the most well known numbers in finance. People see them offered for term deposits and other cash investments, they see them on their mortgages and it is widely covered by the media.

However, despite this, there is sometimes confusion about the underlying interest rate. The Reserve Bank of Australia (RBA) sets the interest rate at a meeting on the first Tuesday of every month (except for January). This interest rate sets a benchmark for all of the other interest rates in the market. Generally, financial institutions will need to move their interest rates in the same direction and by a similar magnitude as the RBA. Why the financial institutions need to do this is beyond the scope of this article however if a bank decided not to cut interest rates, other banks will force it to cut interest rates by cutting theirs (and competition brings the market down).

So the question often asked by people is where I can see interest rates in the next twelve months. In no way is this an exact science but we do have a few guiding principals:

• The inflation target for the RBA is between 2 and 3%
• If the above target is met, the RBA will consider the general economy

If the economy is going very well, inflation picks up and so the RBA will raise interest rates to keep the inflation rate in check. By raising interest rates, it reduces the amount people want to borrow and also their disposable income (on floating variable mortgages). When the economy is not going so well, the RBA will cut interest rates to make people consider spending more (larger disposable income and lower rate of borrowing).

Interestingly, the central bank (the RBA is just one of the global central banks) in other economies where a majority of mortgages are fixed (i.e. set interest rate), this tool becomes less effective than it does in Australia where a larger percentage of mortgages are variable. In the US, a fixed mortgage for up to 30 years is actually quite common.

Finally, the inflation rate has a lag, that is, we aren't seeing the inflation rate today but the inflation rate a few months ago so once again, some judgement is needed. The RBA website (http://www.rba.gov.au/) contains the most recently recorded inflation rate on their home page. If you see this number up in the high twos or over three, you should expect interest rate rises.