What is the cash rate and how does it affect you?

Official interest rates, also known as the cash rate, have been the source of countless news stories in recent years, with each movement generating plenty of chatter about the state of the economy, monetary policy, and the general direction it’s all heading.

But what do changes to the cash rate mean for everyday Australians, particularly those with a home loan or savings account? We take a look at how the cash rate works and how exactly it affects you.

The cash rate is a monetary policy tool used by the Reserve Bank of Australia (RBA) to control the amount of spare cash in the economy. A high cash rate reduces people's spending power, while a low cash rate increases it.

How does the cash rate work?

Banks and lenders use the cash rate as a benchmark to set the interest rates on ‘overnight’ funds. These are the funds banks lend to one another to meet their daily cash needs.

Since these funds make up a large part of a bank's operating costs, banks also use the cash rate to set interest rates on money-makers like mortgages, savings accounts, and term deposits.

This means every time the RBA makes changes to the cash rate, the products we use every day, like mortgages and savers, become more or less expensive to use.

A high cash rate makes loans expensive but savings more attractive; a low rate cash makes loans cheaper and savings less attractive. 

This gives the cash rate a lot of indirect power of the economy. Cheap loans and bad savings rates encourage spending, and vice versa. This is why the cash rate an important tool for steering the economy in a desired direction, from spending, investment, and employment to inflation.

Essentially, when the economy is strong and demand is high, the RBA might decide to raise the cash rate to slow things down a bit and ensure inflation stays within a healthy range.

If, on the other hand, the economy is weak and demand is low, the RBA might lower the cash rate to encourage spending and investment, giving the economy the boost it needs.

The Reserve Bank of Australia is the country’s central bank. It functions as the primary decision-maker when it comes to monetary policy.

According to its charter, the RBA’s goal is to promote:

• The stability of the currency of Australia.
• The maintenance of full employment in Australia.
• The economic prosperity and welfare of the people of Australia.

Eight times a year, the RBA board meets to discuss whether the official cash rate should be increased, decreased, or left as it is. The meetings last two days (Monday and Tuesday). Their decision is announced at 2:30 pm on the Tuesday. Any change to the official rate will take effect the next day.

In the lead-up to a cut, the RBA will usually try to set the stage. It has a reputation for being a cautious organisation: doing anything too abrupt would be out of character. Quick decisions made without first paving the way for them is generally what happens when there’s an emergency, like a global pandemic.

There are a number of items on the agenda when the RBA board meets.

Here are just some of the things the board takes into account when deciding what changes to make to the cash rate, if any.

Inflation

The RBA has a flexible inflation goal of 2%  to 3%, often called the "target band".

This means that while inflation is allowed to fall outside this range, at least temporarily, it should remain within 2% and 3% on average.

If inflation is too high, the RBA might raise the cash rate to ensure Australians retain their purchasing power.

Employment

The level of employment (and unemployment) in the country is a solid indicator of how well the economy is performing.

If unemployment is on the rise and a recession is imminent, the RBA might choose to lower interest rates to stimulate spending, investment, and the creation of new jobs.

Economic growth

If economic growth has slowed or is on the way down, the RBA might lower the cash rate to bring demand back up. The key indicator of economic growth is usually Gross Domestic Product (GDP). 

The international economy

Global financial conditions also feature prominently in the RBA’s deliberations.

Strong economic growth overseas can mean increased demand for Australian products. But if overseas conditions are weak, or if there are tensions among our major trade partners, it could hit Australia’s economy hard.

The cash rate is one of the main factors mortgage lenders take into account when setting their home loan interest rates, so any increases or decreases will usually flow through to borrowers.

That said, it’s not the only factor — banks also need to consider their operating costs, such as staff, marketing, and interest paid out to savers. In the case of a rate cut, banks are by no means obligated to pass it onto their customers in full.

Nonetheless, even a modest decrease in interest rates can translate to a sizeable reduction in borrowers’ mortgage repayments and thousands saved over the life of a loan. By the same token, an increase in interest rates will lead to larger repayments.

The below graph illustrates how the average variable rate for different borrower types has moved in line with the cash rate over the years.

Average variable rates in Australia

How busy the property market is has a lot to due with how expensive it is to get a home loan.

For instance, lower interest rates can make mortgages much more attractive. This is why property booms tend to follow RBA rate cuts.

Higher interest rates have the opposite effect — as the cost of borrowing goes up, demand tends to cool off. The drop in home buyer competition usually tanks prices, even if just a little.

Savings accounts also move in line with the cash rate, meaning that if the cash rate goes up, you can expect much more attractive returns on your savings.

The hope is to keep inflation from getting out of hand by encouraging people to save more and spend less, though this will depend on the person's lifestyle and job security.

If, on the other hand, the cash rate goes down, interest rates on deposits will go down with it. While banks aren’t guaranteed to pass on the full cut to their mortgage customers, you can bet they won’t hesitate to pass it onto savers.

While countries like Japan and Sweden have taken interest rates below zero, it’s unlikely that Australia will go down the same path.

While low interest rates can help boost spending and investment, there are concerns that negative interest rates will impact consumer confidence, causing Australians to hold onto their money rather than pour it back into the economy. 

For more information about the cash rate and how it affects households’ finances, visit our home loan statistics page, where we provide a historical overview of the home loan market in Australia.

Home loan rate change calculator