Understanding Interest Rates
Where do Interest Rates fit into the picture?
Movements in the cash rate are quickly passed through to other capital market interest rates such as money market rates and bond yields. These interest rates are also influenced by the risk tolerance of investors and preferences for holding funds in a form that are readily redeemable.
The cash rate and other capital market interest rates then feed through to the whole structure of deposit and lending rates. In Australia, most deposits and loans are at variable or short-term fixed rates, so there is a high pass through of changes in the cash rate to deposit and lending rates. But because of the other factors influencing capital market rates, and fluctuations in the level of competition in the banking sector, deposit and lending rates do not always move in lockstep with the cash rate.
The changes in interest rates affect economic activity and inflation with much longer lags, because it takes time for individuals and businesses to adjust their behaviour. Interest rates affect economic activity via a number of mechanisms (Interest Rate Pressures Map). They can affect savings and investment behaviour, the spending behaviour of households, the supply of credit, asset prices and the exchange rate, all of which affect the level of aggregate demand. In turn, developments in aggregate demand, in conjunction with developments in aggregate supply, influence the level of inflation in the economy. Inflation is also influenced by the effect that changes in interest rates have on imported goods prices, via the exchange rate, and through their effect on inflation expectations more generally in the economy.
The ways in which monetary policy affects the economy are far from mechanical in their operation. In aggregate, however, a general negative association between interest rates and both demand growth and inflation is clear. Major rises in interest rates in 1981/82, 1985 and 1988/89, which were designed to restrain inflationary booms, were all followed by contractions in demand and a reduction in inflation. The smaller interest rate rises in 1994 were similarly followed by an easing in demand growth and inflation. Conversely, major interest rate reductions have been followed by periods of significantly faster growth, as happened for example in the early 1990s. In responding to cyclical developments and inflationary pressures, monetary policy has thus had a powerful influence on aggregate demand and inflation in the economy.