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Interest Rates - How Are They Determined?

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The Reserve Bank of Australia (RBA) is an independent body that determines the direction of interest rates based on a number of economic factors. As stated by the RBA their main aims are as follows:

"The Reserve Bank of Australia's (RBA) main responsibility is monetary policy. Policy decisions are made by the Reserve Bank Board, with the objective of achieving low and stable inflation over the medium term. Other major areas are maintaining financial system stability and promoting the safety and efficiency of the payments system. The Bank is an active participant in financial markets, manages Australia's foreign reserves, issues currency notes and serves banker to the Australian Government"

When determining interest rates the RBA considers the following economic factors.

Inflation

Defined as the increase in the prices of goods and services.

The higher rate of inflation the faster the purchasing power of consumers erodes - what a dollar buys you becomes less and less as inflation increases.

Inflation is what really influences the changes of Official interest rates. The RBA generally likes to keep inflation between the 2-3% mark, however, this may change as a result of international pressures.

Generally, if inflation is seen to be increasing at a rate that is disproportionate to the health of the economy - or basically growing faster than it can sustain - then official rates may be raised to in order to reduce consumer spending and slow down the economy.

Alternatively, if inflation is not increasing at a healthy rate, the official rate may be lowered to give a boost to the economy.

Unemployment Rate

Measures the percentage of the workforce that is currently employed which is measured monthly. Higher unemployment means that business confidence is low which may be a result of a slowing economy. This may result in stable or decreasing official rates.

Consumer Price Index

Measures the change in the prices of a fixed basket of goods and services which can be categorised as normal day-to-day household purchases such as milk, bread, petrol etc.

This is quoted as a percentage monthly change and considered as a benchmark for changes in inflation. If prices of up or remain strong suggests a strong economy. If prices rise quickly means inflation is on the rise and the RBA may consider raising official interest rates.

Retail Sales

Measures the change in monthly retail sales based on figures received by retailers. If sales are down, it is generally sign that consumer spending / sentiment is down which may be the signs of a slowing economy and vice versa.

Although the above factors are determinants in the direction of interest rates, it is not an exhaustive list and the RBA also looks at global and local economic trends to determine how interest rates will move.

Warning: This is a very simplistic view how interest rates may be affected. Please consult your financial advisor for further information