High inflation hurts everyone
Inflation measures how fast prices are rising. When inflation is too high, the cost of everyday items like groceries, clothes and rent can rise too quickly, making it hard to keep up. But it doesn’t stop there: high inflation can feed on itself and quickly get out of control.
One reason that prices can rise too quickly is when total spending on goods and services in Australia is greater than what the economy can sustainably produce. Think of a popular concert. When lots of people want tickets but there aren’t enough available, ticket prices rise more quickly.
So, one way to stop prices from going up too fast is to slow total spending in the economy. The aim is to bring spending more in line with what the economy can produce. This is the RBA’s job – to keep inflation low and stable by keeping the economy in balance.
The RBA raises interest rates to bring inflation down
When inflation is too high (and is expected to stay high), the RBA can raise interest rates to help rebalance the economy. Higher interest rates tend to slow total spending in the economy and this in turn helps to lower inflation. We know higher interest rates are difficult for many Australians. But bringing inflation down is important because high inflation hurts everyone.
The RBA raises interest rates by changing the ‘cash rate’, Australia’s official interest rate. Changes in the ‘cash rate’ influence other interest rates across the economy, including rates on home loans, business loans and savings accounts.
Interest rates influence the spending, saving and borrowing decisions of all households and businesses. This makes interest rates an effective tool for managing inflation.
Let’s step through some examples.
Higher interest rates slow household and business spending in four main ways
Higher interest rates increase the benefits of saving and the cost of borrowing. This encourages people to save more and spend less if they can.
How does this affect different people and businesses?
aspiring first home buyer
Jasmine is saving for her first home.
When interest rates rise, it becomes more expensive to take out a home loan. At the same time, Jasmine also earns more interest on the money in her savings account.
She decides to save a little longer and delays buying a home.
renting
Alex rents an apartment and is saving for a car.
When interest rates rise, he earns more interest on the money in his savings account.
Alex chooses to put more of his income into savings where he can to build them up and spends a bit less on other items.
domestic retailer
Sneaker Co is planning to open 10 new stores across Australia.
When interest rates rise, it becomes more expensive to borrow money to fund their expansion.
Sneaker Co decides to borrow less and scales back its expansion plans to only 7 new stores.
Higher interest rates increase loan repayments for households and businesses who have debt. With more money going towards loan repayments, less money is available to spend elsewhere.
How does this affect different people and businesses?
mortgage holders
Thomas and Jane have a variable rate mortgage.
When interest rates rise, their mortgage repayments go up. This means more of their income must go towards their home loan and less is available for other spending.
They cut back on some spending, by going out to dinner less and delaying plans to replace their car.
hair salon owner
Sharon owns a small hair salon and has a business loan.
When interest rates rise, her loan repayments go up. This means she has less money available for other spending she has planned, such as new hairdryers or a new shop sign.
Sharon decides to delay her planned business spending until later.
data centre developer
BigData Co is building a new data centre and has borrowed money to finance the project.
Because higher interest rates increase the company’s loan repayments, more of its cash must go towards its interest bill.
With less money available to fund new developments, BigData Co delays its spending on other projects.
Higher interest rates can increase the value of the Australian dollar. See why here. This makes goods and services from overseas cheaper and Australian-made goods and services more expensive. Australian households and business might then choose to spend less in Australia and more overseas.
How does this affect different people and businesses?
university student
Lily is deciding whether to take a holiday in Australia or travel overseas.
Because higher interest rates increase the value of the Australian dollar, this makes overseas travel cheaper for Australians.
Lily chooses to travel overseas instead of spending her money within Australia.
furniture retailer
Mary owns a furniture store.
Because higher interest rates increase the value of the Australian dollar, the cost of furniture imported from overseas is lower.
Mary decides to purchase more furniture from overseas and to purchase less from Australian suppliers.
export business
Mining Co exports iron ore overseas. Because higher interest rates increase the value of the Australian dollar, Australian iron ore will cost more for overseas buyers.
Some customers reduce their orders from Mining Co and decide to purchase more from other countries instead.
With less revenue, Mining Co delays building a new maintenance facility.
Higher interest rates can reduce the value of homes, shares and other assets. When households and businesses feel less wealthy, they may choose to spend less.
How does this affect different people and businesses?
homeowners
Mark and Helen own their home and have fully paid off their mortgage. Their total wealth is tied to the value of their home.
Higher interest rates can mean house prices grow more slowly or even fall.
Mark and Helen notice house prices are not increasing in their area and feel less wealthy, so they decide to delay their bathroom renovation.
cafe owner
Carlos wants to renovate his café and buy a new coffee machine. He will use his house as backing for a loan.
Higher interest rates can mean house prices grow more slowly or even fall. The value of Carlos’ home declines a little, which reduces how much the bank will lend to him.
Carlos postpones his renovation and only purchases the coffee machine.
worker nearing retirement
Sunita is approaching retirement and has most of her savings in superannuation.
When interest rates rise, the value of the shares in her super can fall. This reduces the value of Sunita’s super and her overall wealth.
Sunita decides to spend less on her upcoming holiday, and instead saves more for retirement.
Overall spending in the economy slows
Higher interest rates affect all households and businesses, regardless of whether they currently have a loan.
When millions of households and businesses decide to reduce their spending even a little, it makes a difference. Over time, spending slows across the economy.
Slower spending leads to lower inflation
When spending slows and comes more in line with how much the economy can produce, prices don’t rise as quickly.
For example, if higher interest rates mean less families go on holidays or they choose shorter holidays, then hotels and caravan parks will have more vacancies, and their prices won’t rise as quickly.
The same mechanism also works for many other prices in the economy. Slower spending helps inflation return to a low and stable rate, within the RBA’s target range of 2 to 3 per cent.