Explained: The difference between the RBA Cash Rate and interest rates

Unless you've been hiding under a rock in recent years, you'll have heard of the cash rate. You've probably also seen lots of news of interest rates, which are more familiar to the typical consumer.

It's easy to confuse talk of the cash rate with discussions on interest rates, and vice versa, but the two differ notably.

The cash rate is the major driver of interest rates and interest rates impact the finances of Aussies, particularly those with home loans.

Let's dive deeper.

What is the cash rate?

The cash rate has many uses. It's a key pillar in the Australian economy, after all.

One of its important functions is being the rate that banks charge each other to borrow money overnight.

Banks must end each day with enough cash to meet liquidity ratios, meaning they can't lend out every dollar deposited by consumers. Often, they need to borrow money for the night to meet these requirements.

That's where the cash rate, sometimes called the 'overnight money market interest rate', comes into play.

One bank might ask another if it has spare cash. If it does, the borrowing bank pays interest at the cash rate.

What are interest rates?

Interest is also what banks charge to borrowers and give to depositors. If you have a savings account, chances are you've been given interest at some point. If you've had a loan, you've probably had to pay interest.

An interest rate is how a bank or lender communicates how much interest it will be charging to borrowers or providing to depositors each year. It's expressed as a percentage of the loan balance.

So, if you have a $100,000 home loan at a 6% per annum (p.a.) interest rate, you might expect to pay $6,000 of interest a year (6% of $100,000 is $6,000).

What's the relationship between the RBA cash rate and interest rates?

How are the cash rate and interest rates related? Well, the higher the cash rate, the higher the interest rates lenders tend to charge borrowers.

That's because, the higher the cash rate, the higher the cost of doing business is for banks, and they'll typically try to recoup their extra costs by increasing interest rates on home loans and other debt products.

Lenders generally reach out to home loan borrowers in the days and weeks following a cash rate movement to alert them that their rates are about to change.

For example, after a cash rate increase, lenders typically inform variable rate home loan borrowers that their rates will rise. Of course, fixed rate home loan borrowers are spared from interest rate changes during their fixed rate period.

Though, not all lenders will adjust interest rates after every cash rate movement. The response to changes in the cash rate can vary among lenders due to several factors, including their funding costs, the level of competition between banks, and their overall business strategy​.

Some lenders might choose to absorb the cost of cash rate increases in an effort to maintain customer loyalty or market share, for instance, while others might pass on the full cost straight away.

Why might the RBA change the cash rate?

The cash rate has been cut, sliced, diced, and hiked amid the pandemic and the following cost of living crisis.

Each change in the cash rate is deliberated carefully by the Reserve Bank of Australia (RBA) board, which meets every six weeks.

The RBA board uses the cash rate to stabilise the Australian economy. And perhaps the most destabilising force present in the economy is inflation.

Inflation drives the cost of goods and services up and, therefore, the value of each dollar down (as inflation means that each dollar gets you fewer goods or services). We need a certain level of inflation in the economy to stimulate economic growth. But too much inflation can be disastrous.

The RBA board aims to keep inflation in the realms of 2% to 3% a year. If inflation is too high, the board might increase the cash rate – as we've seen since mid-2022 – and if inflation is too low, it may drop the cash rate – as it did in 2020 and 2021.

The chart below shows the relationship between the Australian Bureau of Statistic's annualised inflation rate (measured monthly) and the cash rate.

So, what can influence inflation? The answer is demand and supply.

How supply and demand imbalances impact inflation

Too much demand and not enough supply leads to increased inflation, while too little demand and too much supply can lead to lower inflation.

Let's use a fruit stall as an example to illustrate how an imbalance of demand and supply can impact inflation.

Let's imagine a fruit stall that can sell 100 apples a day, and has 120 customers willing to buy apples each day. The stall's owner might decide to increase the price of each apple to A) discourage some customers from buying and B) increase their income.

If, however, the fruit stall only saw 80 customers a day, its owner might choose to reduce how much it charges per apple to encourage more people to purchase.

How does the cash rate influence inflation?

The cash rate influences inflation by essentially making it harder to access money.

If borrowing money becomes more expensive, people and companies will presumably be less likely to take on debt and might be forced to tighten their purse strings.

In the case of the fruit stand, it might find its customers dwindle after a cash rate hike, as those who might have otherwise bought apples look to reduce their spending and funnel more money into managing debt repayments. The stall owner would therefore have little reason to increase prices.

On the other hand, the stall might find lots more people want apples after a cash rate cut, as they have more money to spend. The stall owner might increase prices as a result.

Why banks and lenders change interest rates outside of cash rate moves

Banks might change interest rates independently of cash rate moves to attract customers, manage profitability, or respond to market conditions.

For example, they may raise home loan rates to improve margins or offer a higher savings rates to attract depositors.

Ultimately, banks are businesses and they need to make sure they stay profitable.

Whatever the reason, banks and lenders don't need to wait until the cash rate changes to make changes to their interest rates on offer. Though, they do typically need to give customers some notice.

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Important Information and Comparison Rate Warning

RBA cash rate vs interest rates

	RBA cash rate	Typical bank interest rates
Definition	The rate at which banks lend to each other overnight.	The rate charged by banks on loans and paid on deposits.
Set by	Reserve Bank of Australia (RBA)	Individual banks and financial institutions
Purpose	To influence economic activity, inflation, and employment.	To provide profit for banks on loans and savings accounts.
Frequency of changes	Typically reviewed every six weeks	Can change anytime based on market conditions, competition, and cost of funds.
Impact of rate change	Directly influences overall economic conditions and monetary policy.	Affects monthly repayments for loans and returns on savings.

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