Interest Rates: The Facts

Why do interest rates have to be set by the Reserve Bank? And why is the Reserve Bank so powerful that even the Federal Government cannot tell it what to do?

The need for a central authority to set interest rates has been proved by bitter experience. Runaway inflation, stock exchange crashes, plunging currency values, debt defaults and runs on banks have all occurred around the world when a country’s monetary policy is either non-existent or incompetently handled.

Put simply monetary policy, including the setting of interest rates, is too fundamental to the functioning of a modern, sophisticated economy to be left to chance.

Why then is it not the government of the day, which after all controls every other aspect of our lives, that decides whether interest rates go up or down?

The answer you hear most is that politicians cannot be trusted to do the right thing with interest rates because they always have an eye on what is best for them at the next election, never more than three years off, while management of interest rates requires a more measured, longer-term view. Apart from being rather cynical, this answer is too simplistic.

Of course politicians and ministers like to see low interest rates, especially if they have linked a low interest rate regime with their ability to manage the overall economy competently, but most politicians realise the negative effects of pegging interest rates below what they should be will quickly outweigh any initial advantages.

The feeling in most developed economies around the world is that an independent expert body, not bound up in the electoral cycle – in our case the Reserve Bank – will be better at the highly technical job of maintaining and promoting the stability of the financial system than politicians.

That is not to say the Reserve Bank Board has a monopoly on wisdom, and its experts are in continuous and close consultation with those of the Department of the Treasury as well as taking soundings in the financial and business communities at large. It then meets on the first Tuesday of each month (except January) makes its decision, announcing it the following morning just before the markets open for the new trading day.

Their rulings are never made lightly, and in full awareness they will often affect some sectors of our complex society more severely than others. Unfortunately rate rises have some of their greatest impacts on housing as they immediately flow through to rises in the rate of interest charged on home mortgages, lifting often substantial amounts straight out of homeowners’ pockets.

However, until a better system is devised, we will just have to grit our teeth as we wait for the Reserve Bank’s monthly pronouncement.

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