What drives domestic interest rates?

1. Understanding Interest rates Andrew Hayes

2. This document has been prepared by Wealth Engine Pty Ltd ABN 38 142 579 an Authorised Representative of WealthSure Pty Ltd AFSL 238030 and is intended to be a general advice only. The document is not intended to be comprehensive and should not be relied upon as such. In preparing this document, we have not taken into account the individual objectives or circumstances of any person. Legal, financial and other professional advice should be sought prior to applying the information contained in this document to particular circumstances. Wealth Engine Pty Ltd, its officers and employees will not be liable for any loss or damage sustained by any person acting in reliance on the information contained in this document. General Advice Only

3. A rate which is charged or paid for the use of money. An interest rate is often expressed as an annual percentage of the principal. It is calculated by dividing the amount of interest by the amount of principal. What are interest rates?

4. Reserve Bank of Australia The Reserve Bank of Australia is Australia’s central bank. It conducts monetary policy, works to maintain a strong financial system and issues the nation’s currency. As well as being a policy-making body, the Reserve Bank provides selected banking and registry services to a range of Australian government agencies and to a number of overseas central banks and official institutions. It also manages Australia's gold and foreign exchange reserves. Who sets interest rates?

5. Monetary policy involves setting the interest rate on overnight loans in the money market. Other interest rates in the economy are influenced by this interest rate to varying degrees, so that the behaviour of borrowers and lenders in the financial markets is affected by monetary policy (though not only by monetary policy). What is monetary policy?

6. The Reserve Bank Board sets interest rates so as to achieve the objectives set out in the Reserve Bank Act 1959 the stability of the currency of Australia; the maintenance of full employment in Australia; and the economic prosperity and welfare of the people of Australia. Why use monetary policy?

7. Since 1993, these objectives have found practical expression in a target for consumer price inflation, of 2–3 per cent per annum. Monetary policy aims to achieve this over the medium term so as to encourage strong and sustainable growth in the economy. Controlling inflation preserves the value of money. How does the RBA achieve it?

8. Inflation and expected inflation. The risk premium reflecting the ability of the borrower to repay the debt The supply of funds from savers, primarily households. The demand from borrowers to be used to finance capital expenditure. The global economic cycle. Other factors that influence rates

9. The percentage increase in the price of goods and services, usually annually. In Australia it is measured by the Consumer Price Index (CPI) The simplest way of thinking about the CPI is to imagine a basket of goods and services comprising items typically acquired by Australian households. What is inflation?

10. Inflation?

11. Inflation?

12. Inflation and the term structure of interest rates. Economist Irving Fisher argued that the nominal rate of interest should move one for one with expected inflation. R = r + E(i) This is represented graphically by the yield curve, which also shows the relationship between short and long term interest rates.

13. The yield curve for Government Bonds 25th May 2010 Source Bloomberg.com

14. How Banks price their loans

15. The cost of the banks funds at a wholesale (bond issuance) and retail level (deposit base). The security you offer, such as a registered first mortgage over real estate. Your cash flow and interest serviceability ratio. Your credit history and risk to the institution. Your loan terms and conditions, ie fixed interest versus variable, principal and interest versus interest only and duration of the loan. The market segment the banks are pursuing at any particular time. Factors influencing the rates the bank is willing to lend to you include.

16. Standard Variable Home Loan Interest Rates 1959 - 2010 Australia Source RBA

17. Where do you think rates are going? What do you think the long term average standard variable home loan interest rate has been? Would you fix or stay variable? What factors do you think will impact the banks and non bank lenders going forward? Discussion