Interest Rates 101

The monetary policy committee of the SA Reserve Bank decided on Thursday to cut the repo rate by half a percentage point to 11.5%.

What is the repo rate?

By law, banks must have a certain amount of cash on hand. To meet this requirement, they regularly borrow money from the government-controlled Reserve Bank. The interest rate that the Reserve Bank charge is called the repo rate. If that changes, the banks usually follow suit and change their rates. (Prime rates are the interest banks charge highly regarded customers.)

The repo reached 13.5% in September 2002, before it fell to 7% by April 2005.

The bank started to hike the repo rate again in June 2006.

Why?

The Reserve Bank's main mission in life is to keep inflation between 3% and 6%. (Inflation is the rate at which your money loses buying power every year.)

Currently, inflation is 12.4% – more than double the maximum level of 6%.

The main way the bank tries to tame inflation is by raising interest rates. If credit is expensive, people will buy less and the demand for products will drop. If demand shrinks, prices usually also decrease. (The more money chasing products, the higher sellers can push prices.)

The Reserve Bank also keeps a watchful eye on the rand. If the rand weakens against other currencies, it's bad news for inflation. Imports become more expensive, pushing up prices in SA.

The rand's value is largely determined by foreign buyers. Many buy rands because they earn fat SA interest rates, compared to the paltry rates on offer elsewhere. In the US, rates are down to 1%, while in Japan, yen buyers get less than 0.3%.

By keeping interest rates high, the Reserve Bank supports the rand.

This is important, because South Africa has one of the biggest current account deficits in the world. The current account is the difference between what we export and what we import. SA imports much more than it exports. To buy the imported products, you have to sell rand and buy another currency, putting a strain on the rand.

So why the change in heart?

Inflation has started to come down (from 13.6% in August) and will probably slump spectacularly next year.

The oil price – which has fallen from more than $147 a barrel in July to below $40 this week – will contribute to lower prices for all products that need to be transported. Food prices should also drop thanks to good crops.

There are also technical reasons. The consumer price index, which measures the inflation ordinary South Africans experience, is based on a set selection of goods and services. The composition of this "basket" has been changed and will come into effect from January 2009. Economists expect the change to decrease the inflation number.

Also, a rate-cut frenzy has gripped the world amid the worst financial crisis in 80 years. Twenty of the world's richest countries have slashed interest rates, some coming close to 0%. As more countries lower their interest rates, it means we can too – without putting the rand in much danger.

Probably one of the main reasons behind the Reserve Bank's decision, however, was the alarming slowdown in the SA economy. The latest data showed that parts of the economy – including retail – are already shrinking. This shows consumers aren't spending money, which should also help inflation.

What does this mean for you?

If the rand stays relatively stable, some economists expect interest rates to come down another 3.5 percentage points next year. This means that a monthly repayment on a home loan of R500 000 will be more than R1 400 cheaper by the end of 2009 than it was earlier this year.

Your car instalment and others loan repayments should also come down. And for savers, lower interest rates mean you'll earn less on your savings.

But some experts hope that the rate cut will get the struggling housing market a boost. And for many debt-ridden South Africans, this will be the first break they've had in a while.