So, how are interest rates set in this country?
Well, once upon a time, they used to be set by the government. And the Reserve Bank of Australia used to lend money, well lend money to other banks, and those banks lend money to you. Now, the reserve bank lends that money at a variable rate to the banks and then the banks lend it to you at a mark-up. And that’s how the banks make their money.
Now, once upon a time, the reserve bank used to be told what to do with interest rates by the government and by public servants.
But it was decided during the recession of the 90s by Paul Keating in his government that we needed to put a stop to that. What we needed to do instead was establish an independent board that would tell the reserve bank what to do with interest rates.
And that way, they took the political element out of the setting of interest rates, because the interest that the reserve bank collects is revenue for government. So, parties would get elected and want to pay for their promises, so they would then ratchet up interest rates. It wasn’t healthy for the economy and gave us the recession that we had to have.
Once the reserve bank board was made independent, they were told to keep inflation to 2-3%. Now, how do they do that?
Well, the ABS does every month, does its inflation figures. And it considers in there the price of milk, the price of bread, the price of petrol, everything. And then reports an inflationary figure.
Now, if inflation is taking off, the board will put the interest rate up. In turn, the banks will put their interest rate up on you, and you will have less money in your bank account. And if you have less money in your bank account, you’ll do less spending. And if you do less spending, then that’s going to reduce the pressure on inflation.
Conversely, if the economy is stalling, the reserve bank will drop the interest rate. In turn, the banks will drop their interest rates to compete with each other and retain your business, and you will have more money in your bank account. And if you’re like 9/10 Australians who are hopeless with their money, what will you do with that money? You will spend it. And if you are spending it, what will that do to the economy? It will stimulate the economy.
It’s a brilliant system, it’s the envy of many countries, and it’s what saved us from the global financial crisis. Because when the global financial crisis hit Australia, the independent board of the reserve bank dropped interest rates about 4.5% in the space of 6 months.
Now, when the global financial crisis hit Australia, I had a multi-million-dollar property portfolio. I wasn’t worried about the global financial crisis. I was like, crisis? What crisis? Interest rates hadn’t been so low, and now they’re even lower, it’s fantastic!
If you look at the historical base, and on this graph, you can see that the reserve bank rate’s the blue line, and the retail rate the banks lend is the black line. And as you can see, its slightly higher all the time, which is a bit of a glitch there on the 1990 figure. But its slightly higher all the time, because that’s how the banks make their profit.
Now, if you understand this system of how the interest rates are set, you can understand all these events. So this, 1990, was when we were at the height of the recession. Double digit interest rates. And that was also when the board was made independent. As soon as the board was independent, they started driving the interest rates down to stimulate the economy.
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