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How does raising interest rates curb inflation?

Alex Ritchie avatar
Alex Ritchie
- 6 min read
How does raising interest rates curb inflation?

After a decade of lowering the cash rate, the Reserve Bank of Australia began hiking rates in 2022 in an effort to curb rising inflation levels.

A higher cash rate generally means higher interest rates on credit products like home loans, and deposit accounts like term deposits and savings accounts. And while you may understand how this can significantly impact your household budget, you could be curious as to how exactly raising rates stops inflation.

Put simply, by raising interest rates on credit products, consumers and businesses are less likely to borrow funds - and any existing borrowings become more expensive to service. This means consumers and businesses now have less money to spend. When spending decreases, theoretically this should slow down economic growth and in turn, reduce prices.

What is inflation?

The Reserve Bank of Australia (RBA) defines inflation as a measure of the change (increase) in the general level of prices over time. Inflation in Australia is typically calculated by the Australian Bureau of Statistics (ABS) and measured quarterly or annually.

Think of it like this - a basket of goods, such as bread, milk, and eggs, cost you $12 last year and $12.50 today. You may determine that annual inflation for those items is 4%. This economic indicator is the same reason that, say, a ticket for a movie or a bag of lollies was so much cheaper 50 years ago than it is today.

The three biggest influencing factors of the current inflation rate are the cost of production, demand for said goods and services, and fiscal policy.

  1. Demand-pull inflation refers to when the demand for goods or services is greater than the production capacity e.g. if a designer creates an exclusive sneaker style or limited-edition handbag. The lack of supply paired with significant demand allows the seller to lift prices.
  2. Cost-push inflation simply refers to when the production costs involved in creating said goods or services increases, and therefore the prices increase accordingly. For example, if there is an increase in the price of a material to build an appliance, the price of the appliance may increase too.
  3. Built-in inflation occurs when employees seek higher wages to keep up with the rising cost of living. This in turn can see businesses increase their prices to afford higher wages for their employees, and so on.

How is inflation measured in Australia?

In Australia, the ABS looks to the Consumer Price Increase (CPI) to indicate inflation levels. This is our measurement of the percentage change in the value of goods and services, such as in the basket of goods example above.

The CPI groups it measures includes:

  • Food and non-alcoholic beverages
  • Alcohol and tobacco
  • Clothing and footwear
  • Housing
  • Furnishings, household equipment and services
  • Health
  • Transport
  • Communication
  • Recreation and culture
  • Education
  • Insurance and financial services

Why does raising interest rates stop inflation?

Inflation is a macroeconomic indicator that helps to influence how the RBA will or will not change the cash rate. Inflation itself is not necessarily a bad thing; in fact, steady and well-managed inflation is a sign of a growing economy.

The idea is that when inflation starts rising too quickly, as it appears to be in 2022, one way to curb its growth is by decreasing our spending.

Through hiking the cash rate, interest rates on credit products become higher and debt becomes more expensive. Interest rates on savings should also increase, giving those keeping their nest eggs in a savings account or term deposit higher returns.

By increasing the cost of borrowing money for both consumers, businesses, and the banks, no one can easily borrow as much money as before, and therefore spending decreases. Plus, if goods and services are more costly you may be more likely to keep your cash in your savings account, so spending once again decreases.

By slowing down spending, you should, in theory, slow down economic growth. And when you’re experiencing annual inflation levels near 8%, supply chain issues, global conflict and low wage growth, ensuring that everyday Australians can still afford their weekly groceries is crucial for any central bank.

Why is inflation on the rise in Australia?

Currently, inflation is on the rise due to several external factors. These include the impact of global supply chain issues and the Russian invasion of Ukraine, which has caused significant delays in the supply of goods like wheat and barley, as well as crude oil.

In its latest release, the ABS stated that the past four quarters saw strong quarterly rises off the back of higher prices for food, automotive fuel and new dwelling construction. These factors influence higher inflation levels in the following ways:

  • Higher prices for food: All food and non-food grocery products saw an increase in prices. Whether due to the impacts of the Queensland floods on transport and supply, or increased input costs, this meant the price of groceries were more expensive.
  • Record-level fuel prices: Oil price shock caused by the Russian war in Ukraine, plus the ongoing easing of COVID-19 restrictions, has meant oil supplies are limited and demand has increased. This resulted in the biggest annual rise in prices since 1990.
  • Higher construction costs hiking cost of new dwellings: Due to ongoing shortages of materials and labour, construction costs are higher. And with less government construction grants available to reduce out-of-pocket costs for new dwelling purchases, the cost of building and buying a new dwelling has gone up. 

The RBA has also been pointing towards a potential “wage-price spiral” as a risk factor for rising inflation and a cause for hiking the cash rate. However, a recent study by the Australian Institute found that Australia's rising inflation levels are actually being influenced by a ‘profit-price spiral’. Put simply, this indicates corporate profits and not wage growth may be making things worse. 

The study noted that Australian businesses had increased prices “by a total of $160 billion per year over and above their higher expenses for labour, taxes, and other inputs, and over and above new profits generated by growth in real economic output”.

Interestingly, without these excess profits in final prices for Australian-made goods and services, the report added that inflation since the pandemic “would have been much slower than was experienced in practice: an annual average of 2.7% per year, barely half of the 5.2% annual average actually recorded since end-2019”. 

The report concluded that RBA’s target inflation band would have likely been met. Meaning, the last year of painful interest rate hikes would have been unnecessary.

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Product database updated 18 Jun, 2024

This article was reviewed by Personal Finance Editor Mark Bristow before it was published as part of RateCity's Fact Check process.