December 2011 Interest Rate Drop

The Reserve Bank of Australia (RBA) meets on the first Tuesday of each month to decide whether or not to make changes to the cash rate target.

The most recent meeting was earlier this week, when the RBA decided to lower rates by 0.25%. This was the second consecutive monthly reduction in the cash rate target.

Why did the RBA lower rates?

The primary role of the RBA’s cash rate target is to control inflation. Inflation is the word used to describe the increase in the costs of goods. High inflation generally means that the cost of living is increasing at a high rate.

When inflation is high, the Reserve Bank increases rates. This generally has the effect of people spending less of their money, which reduces demand and therefore takes pressures off prices. In times of low inflation they can lower the rate, which increases demand and stimulates the economy.

The December rate reduction was all about stimulating the Australian economy in the face of growing uncertainty in Europe.

Why haven’t the banks lowered their rates yet?

At the time of writing, the only bank to have reduced their rate is the Bank of Queensland. The other banks have not yet made any public comment on if or when they will reduce their home loan rates.

In times such as this when the banks do not immediately follow the RBA’s decision, many people become angry with the banks and demand that the Government force the banks to reduce their rates by the same amount as the RBA.

However, it should be noted that the rate set by the RBA is the ‘Cash Rate Target’. It is not an official interest rate as many in the media state. It is a target rate, and it only reflects the overnight money market.

Whilst the overnight cash rate target does have a major impact on interest rates that banks must charge to remain profitable, there are many other factors at play.

Up to 40% of the funds for Australian mortgages are obtained from overseas wholesale money markets, primarily in Europe and the USA. The global financial crisis (GFC) saw many players in the wholesale money markets become very nervous, which in turn increased the cost of money for banks all over the world.

With the serious problems currently occurring in the European banking system, the cost of money for foreign banks, including Australian banks, has again increased.

Whilst the reduction of the RBA cash rate target certainly helps to reduce the cost of money for the banks, it does not mean that the bank’s costs immediately drop by 0.25%.

Of course we all want our home loan interest rates to drop as low as possible, but we also need healthy banks in Australia. The last thing we want is for the Government to have to spend trillions of our tax dollars bailing out banks like we’ve seen across Europe and the USA.

Handy tips for when rates drop

Whenever your bank reduces its interest rate, you should always try to maintain your repayments at the same level rather than reducing your repayment and spending the savings elsewhere.

This will help to reduce your loan balance sooner whilst rates are low, and will also mean that any future rate increases will be much easier to handle since you are already paying the higher amount.