By guest contributor Terry Toohey, Senior Consultant, Ex-Head of Westpac fixed interest
Australia’s official interest rate is known as the overnight cash rate, or just the cash rate for short. It is the rate at which banks and other financial institutions which have accounts at the RBA borrow from and lend to each other on an overnight basis. However, it also forms the basis for interest rates in the wider economy due to the ability of banks and other institutions to borrow from or lend to the RBA.
In the past, Australia had no official cash rate, or at least none which the RBA disclosed publicly. The rate of interest banks charged each other on overnight loans was a function of demand and supply of cash, with the RBA supplying additional cash or soaking it up whenever it thought necessary. This changed in 1983 when the dollar was floated and the RBA began to target the cash rate instead of the exchange rate. The RBA only began to publish publicly its target in 1990.
The practice of the RBA setting the cash rate is, at best, ineffective and, at worst, counterproductive.
The future direction of interest rates is at least as important to an investment decision as the current level of rates. A reduction in interest rates can be read as a signal of future interest rate reductions.
If the decision is whether to borrow now to expand or wait until later, then the current interest rate is only part of the reason. A more important question is, “What is the likely level of interest rates in the next three to six months?”
If interest rates are going to fall, then logic dictates that I should wait to take advantage of the lower rates. The corollary is also true that if rates are going to be higher in the future I should borrow now.
Falling interest rates are only an advantage (to a borrower) when they have finished falling.
So, the positive effect of the RBA’s rate drop may be more than offset by an expectation that rates will fall further in the near future.