How does raising interest rates curb inflation?

The 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 monthly, quarterly or annually.

Think of it like this – imagine 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.

In Australia, the ABS looks at the Consumer Price Index (CPI) to indicate inflation levels. This is our measurement of the percentage change in the value of goods and services.

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

Inflation is a macroeconomic indicator that helps to influence the RBA’s decisions regarding 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.

But sometimes inflation starts rising too quickly. For example, at the end of 2022 Australia’s annual inflation was near 8% due to supply chain issues, global conflict and low wage growth. At times like this, ensuring that everyday Australians can still afford their weekly groceries becomes crucial for the central bank.

One way to curb inflation’s growth is by decreasing Australia’s 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 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.

Australia’s inflation rose through much of 2022, influenced by global supply chain issues following the COVID-19 pandemic, and international conflicts like the Russian invasion of Ukraine affecting supplies of wheat, barley and crude oil.

However, inflation peaked at 7.8% in December 2022, and has been gradually declining since then:

• December 2022: 7.8%
• March 2023: 7.0%
• June 2023: 6.0%
• September 2023: 5.4%
• December 2023: 4.1%
• March 2024: 3.6%
• June 2024: 3.8%

Source: ABS

According to the ABS, the biggest contributors to the inflation uptick in the June 2024 quarter were:

• Housing
• Food and non-alcoholic beverages.
• Clothing and footwear
• Alcohol and tobacco

Despite this uptick, inflation is still in line with the RBA’s forecasts at the time of writing, which would see inflation to fall into the middle of its target band (2% to 3%) by mid-2026. Economists from the big four banks have forecast that the RBA could choose to start cutting the cash rate before then, potentially kicking off an easing cycle to commence somewhere between the end of 2024 and early to mid 2025. 

However, none of these forecasts are guaranteed, as the RBA makes its monetary policy decisions based on a wide variety of economic data, and not solely on the inflation figures.