7 Factors the RBA Uses to Evaluate Interest Rates

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The current cash rate of 1.5 per cent is the lowest we have had in Australia. The Reserve Bank of Australia (RBA) has had rates on hold at 1.5 per cent since 3 August 2016. There is always a debate in the market about whether the next move in interest rates sees the rate head higher or lower, and in what time frame. So what are the factors that the RBA evaluates when determining interest rate rises or cuts?

RBA interest rate factors

The RBA considers the following factors when determining interest rates:

  1. Inflation
  2. Unemployment
  3. Wage growth
  4. Household debt
  5. The Australian dollar
  6. Overseas demand
  7. Consumer Confidence Index

Inflation

Inflation is the rising price of goods and services. When inflation occurs, the purchasing power of the consumer is diminished as the cost of living has increased. The RBA monitors inflation and will take into account inflation figures when deciding on interest rate movements. If the RBA thinks inflation is too high they will raise interest rates to slow the economic growth, if they think inflation is too low, they will cut interest rates to boost economic growth.

The current inflation rate is 1.8 per cent which is below the current market expectations of 2 per cent. The RBA’s target inflation rate is 2-3 per cent. We have had a low inflation environment for a while and the RBA has taken this into account when assessing interest rate movements.

Unemployment

Full employment is about 5 per cent. As of October 2017, the unemployment rate was 5.4 per cent. The unemployment rate fell from 5.5  per cent in the previous month. This reflects strong employment conditions in the Australian labour market.  The figures for the monthly full-time employment increased for the 13th straight month in October 2017. The unemployment rate is currently the lowest it has been in four years.

If the RBA sees unemployment as being too high, there is a higher probability they will cut interest rates. This is so businesses can expand further and create jobs.

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Wage Growth

Australian wage growth has been slow with a figure of 2 per cent in recent quarters. Weak wage growth is a factor for the RBA to consider as without higher wages, household consumption is limited. Growth in household debt has been rapid and wage growth has not increased to the same level as housing inflation. For the economy to strengthen, wage growth needs to catch up with house price growth.  These factors remain impeding concerns for inflation.

Household debt

High levels of household debt is a constraining factor for the RBA to raise interest rates. As many Australians have borrowed large amounts for their homes, the RBA will need to take this into consideration as interest rate rises will affect these households immensely.  The RBA has a difficult balancing act of stimulating the economy but also doing it in a way that so it does not jeopardize these highly leveraged households.

The Australian dollar

The RBA monitors the Australian dollar and adjusts the interest rate in accordance to how the exchange rate is performing. If the cash rate is too high then it will encourage investors to invest in the Australian dollar pushing the exchange rate higher. If the Australian dollar is too high then Australian exporters will find it hard to stay competitive in international markets as their goods would be more expensive compared to countries.

Overseas Demand

The RBA will also look at overseas conditions. Construction activity in China have remained robust but they anticipate a reduction in demand for iron ore and coking coal due to environmental policies aimed at reducing air pollution. This construction activity has supported China’s demand for resources in Australia.

Consumer Confidence Index

The RBA will look at this index as an indicator of the level of optimism consumers feel about their personal financial situation. Consumers will spend money on goods and services which increase economic growth when confidence is high. When confidence is low, consumers are more likely to save money and in effect hamper economic growth.

Lauren Hua is a private client adviser at Fairmont Equities.

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