Inflation’s impact: what will drive future interest rate rises and cuts

Borrowers may feel trapped by high mortgage costs, but the pain may be over soon, and it’s worth knowing why that will happen.

To many Australians, it must seem like a seriously messed up way of controlling an economy.

The price of everything has soared, with inflation at its highest level in decades.

So what did the Reserve Bank of Australia do? It put up the cost of everybody’s borrowings by a huge amount, bringing on more pain. Rates rose 10 times in a row before Tuesday’s pause.

Inflation was up more than 8 per cent annually late last year, although the latest monthly Consumer Price Index data released by the Australian Bureau of Statistics in late March showed a lower-than-expected 6.8 per cent year-on-year result for February.

It’s still more than twice as high as where the RBA wants it to be – between 2 and 3 per cent – which is why uncertainty remains about how many more rate rises we can expect in the months ahead. This is also why it’s a good idea to understand how inflation impacts interest rates and the rest of the economy, and why the RBA does what it does.

WHY RAISE RATES?

Put simply, the reasoning behind rate rises is that they take more money out of our pockets so we don’t spend it on stuff, retailers don’t put up prices due to demand from customers and inflation goes back down.

Think of it like a giant machine, with the RBA controlling the brakes and accelerator.

If it wants people to spend less, it lifts its official interest rate.

If it wants them to spend more, it lowers the rate.

The path to interest rate changes can be confusing for borrowers and savers. Picture: iStock

We consumers and borrowers are caught in the machine, and while our individual actions cannot do anything to control its motion, as a group we are the reason for rate rises and rate falls.

WHEN DID IT ALL START?

The Reserve Bank’s objectives date back to 1959 and are to maintain a stable currency, maintain full employment and help ensure the economic prosperity and welfare of Australians.

“Since the early 1990s, these objectives have found practical expression in a target for consumer price inflation of 2-3 per cent per annum,” the RBA said.

This level will “encourage strong and sustainable growth in the economy” and preserve the value of money. According to the RBA, it also prevents distortion of financial decisions.

WHY IS IT AN ISSUE?

Everybody agrees inflation has been too high and should go back down, but there are two big problems with the RBA using rate rises as a sledgehammer to do this.

Firstly, much of the inflation Aussies have suffered stems from outside factors including Russia’s invasion of Ukraine impacting global prices, supply chain squeezes as the world recovers from Covid and natural disasters impacting food costs.

The other big problem is that not everybody is hit by interest rate rises. Only about one-third of Australians have a mortgage, and many of those are well ahead on repayments so don’t feel immediate discomfort.

More pain will be felt this year as low-rate fixed loans revert to high-rate variable loans.

Hopefully, early signs of inflation retreating mean rate rises will reverse sooner.

That will depend on spending, wages and prices, and with luck most people won’t be run over by the RBA rate rise machine.

Originally published as Inflation’s impact: what will drive future interest rate rises and cuts