The mechanics behind interest rates

Posted on: June 23, 2013
Posted by: Bob Budreika

Most people believe interest rates are determined by the Reserve Bank as a result of monthly board meetings.  The primary functions of the RBA are to issue currency and conduct monetary policy in order to achieve the nation’s economic objectives.  What is not well known is that the Reserve Bank only controls short term rates (cash rates) and has little to no influence on longer term rates such as mortgages.

How are longer term interest rates determined?

In general, long term interest rates are set by the global financial markets and are determined like any other commercial transaction.  Lenders will take into consideration the credit risk (including such things as the stability of the Government, national debt level, credit worthiness) and the term of the loan.  Since most countries borrow at one time or another, we in Australia must compete to attract funds.  Not only does the Commonwealth Government borrow from global sources but also our banks and large institutions.  These borrowings are usually issued as bonds (which have a set rate and term to maturity) and are a tradeable asset like property or shares.  What is not well known is that the Bond market is far bigger in size than the total value of all share markets in the world.  Perhaps this is because the markets are not open to the general public.

Where are we in the interest rate cycle?

The highest official interest rate in recent times was 17.5% in January 1990 and today it is 2.75%.  For most of the last 23 years, the general global trend has been down, and compared to the average rate of 5.44%, we are at the low end of the cycle.  Most developed countries have experienced much the same trend with Australia’s current rate being one of the highest.  This is an interesting phenomenon because interest rates are falling at the time of extraordinary national and personal debt levels.

Why are rates falling in an environment where there is so much global debt?

You would be correct in thinking that if someone had a large debt that they’d find it difficult to increase their borrowings – let alone at an attractive rate.  This is exactly what is happening with many nations including USA, Japan, UK and most of the EU countries, who have massive public debt levels.  To avoid borrowing from financial markets, theses governments simply issue bonds to raise capital and then buy them back from themselves.  This has the effect of forcing interest rates down.  To do this they must increase the supply of money which is commonly referred to as ‘printing money.’  This is not a good long term strategy as it distorts a country’s economy and ultimately leads to inflation.  This manipulation of rates also causes mistrust in the bond market.  For a while this works as it is the easiest way to keep citizens happy but eventually there comes a payback time.  Just like someone who lives beyond their means, eventually creating and borrowing money doesn’t work.  One of the signs that there are cracks in an economy is when interest rates rise while the economy is stagnant or recessed.

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