Inflation, rate hikes, and the economy: why the RBA is lifting interest rates

The Reserve Bank of Australia (RBA) remains laser-focused on tackling the “scourge” of high inflation, in part through raising the national cash rate at the fastest pace in decades. So how did inflation get so high, and are the rate hikes that are putting pressure on Australian household budgets really going to fix it?

What is Australia’s current inflation situation? 

In a recent speech to the Anika Foundation, RBA governor Dr Philip Lowe had some strong words to say about the threat that inflation poses to both the Australian economy and the personal finances of everyday Australians:

“High inflation is a scourge. It damages our standard of living, creates additional uncertainty for households and businesses, erodes the value of people's savings and adds to inequality.”

Australia’s inflation is expected to reach 7.75 per cent by the end of the year, which Governor Lowe described as “a very large surprise.” Considering that a year ago the RBA was forecasting that inflation in 2022 would be at just 1.75 per cent, Dr Lowe described this as “a very big change and a very big forecast miss,” one that would lead to “soul-searching” for economic forecasters across the finance industry and the RBA.

How did inflation get so high? 

During his speech and the question-and-answer session that followed, Dr Lowe talked about how Australia’s high inflation can be partially attributed to factors affecting both supply and demand in the economy.

Many supply constraints are understood to be external to Australia, such as Russia’s invasion of Ukraine affecting global fuel and energy prices. Disruption to supply chains at a time of surging demand has also sent inflation upward.

Governor Lowe gave one particular example of Australia’s home building sector, describing how over the past year the cost of building a new home has increased by 20 per cent, which has alone added close to 2 percentage points to headline inflation:

“Very strong demand in this sector – partly due to low interest rates and government grants totalling up to $35,000 for some first home buyers – came up against COVID-related problems on the supply side. The result was a big jump in prices, which has had a material impact on the overall inflation rate in Australia.”

On the demand side of the inflation equation, Dr Lowe said that demand was strong in part because Australians accessed a lot of income over the pandemic years and weren’t able to spend it at the time. He described how the RBA cut the national cash rate to the record low of 0.10 per cent as economic “insurance”, with the health advice at the time forecasting a real risk of catastrophic consequences to Australian society.

But with Australia coping with the pandemic better than expected, lower rates meant more Australians had cheaper access to money. And with pandemic-related restrictions preventing many Australians from spending money as normal, these Australians were also able to build up more savings. Having all this extra money available to spend is now understood to be increasing demand and contributing to higher inflation.

How are rate hikes supposed to help slow inflation? 

Governor Lowe reiterated the RBA’s commitment to returning inflation to the target range of between 2 and 3 per cent. To reach this target, the RBA has raised the national cash rate from the record low of 0.10 per cent to 2.35 per cent in just five months, with more hikes likely to follow.

While these hikes aren’t expected to affect supply-side factors (the private sector is likely to resolve these over time), they may help to slow down demand.

But while inflation is understood to be affecting everything from the cost of fuel to the price of lettuce, higher interest rates are also putting pressure on many household budgets. Australians who are making higher repayments on variable rate home loans run the risk of finding themselves stuck in ‘mortgage prison’, where falling property prices could leave them in negative equity and unable to refinance to a cheaper mortgage.

Governor Lowe acknowledged that higher interest rates are more likely to affect lower-income households with lower savings buffers in their budgets. He added that it’s going to be very difficult for people to accept that wages aren’t picking up with higher inflation, and that these conditions are likely to remain difficult for the next year until inflation comes down.

“As difficult as it is for many people, we need to get inflation back down, and that means higher interest rates. And that means that aggregate demand has to grow a bit more slowly in line with the capacity of the economy to supply it. That’s the reality we face. Because it’s not in anyone’s interests, particularly lower-income people, for the higher inflation to stay high. That will damage the economic prospects of lower-income people, so we’ve really got to get inflation down.”

Governor Lowe also said that some people write to thank him for higher interest rates, as these people rely on higher interest rates for their interest income. When asked where most of the savings buffers in the Australian economy sit, he also acknowledged that these mostly sit with upper- and middle-income households; white-collar workers who kept their jobs but couldn’t spend money during the pandemic and instead put more money into offset accounts.

When questioned about the critics calling for his resignation over previous statements that interest rates weren’t expected to rise until 2024, Governor Lowe responded that he had no plans to step down, and that he never promised rates would stay on hold:  

“People have jobs, kids have opportunity, household income’s rising. That’s what I’d say to people who don’t like me in my job.”

"Interest rates are higher, I know people don't like that, but you should be welcoming the stronger economy, and that's what I'd say to people who are kind of unhappy with the promise, which wasn't a promise. The economy is so much better!"

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