How Does Inflation Affect Interest Rates in Australia?

Interest rates are commonly used to combat inflation. They do this by influencing the spending power of the public. In general, interest rates are raised during times of high inflation, and lowered when inflation slows.

The process of raising or lowering rates is overseen by the Reserve Bank of Australia (RBA). Australia’s current economy is experiencing higher than expected inflation, which has caused the RBA to raise rates. Read more about how this process works and how it impacts you.

What is inflation?

Inflation is typically measured using the Consumer Price Index (CPI), which is calculated by the Australian Bureau of Statistics (ABS), and is published once a quarter. The CPI tracks the cost of goods and services over time. It contains prices for thousands of items, which are grouped into 87 categories (or expenditure classes) and 11 groups, which it then uses to calculate the price changes, aggregate them and arrive at a quarterly figure. To decide what goes into the CPI basket and their respective weighting, the ABS gathers information on exactly what Australian households spend their income on and what percentage of their income is needed.

A steady rate of inflation in the CPI is expected — the RBA has an annual target of 2% – 3%. However, if the CPI increases quickly or unexpectedly, it may have economists concerned.

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What are interest rates?

The RBA sets the ‘cash rate target’ — the rate on overnight loans between banks. This then influences the interest rates set by lenders, banks and financial institutions across the country. The current cash rate target is 4.35%.

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How inflation and interest rates are connected

When the RBA lowers interest rates, consumers are typically more inclined to spend money and take out loans. This increases the demand on goods and services, and places a strain on supply. Businesses may hire more workers to meet the demand, or simply raise prices to take advantage of the ‘in-demand’ market. An increase in prices causes the CPI to rise, which is a marker for inflation.

The reverse is also true. If inflation is high, the RBA typically raises interest rates to reduce consumer spending. Higher interest rates mean consumers are more likely to save money, reduce spending and avoid taking on loans. The decreased demand on the market causes businesses to lower prices — allowing the inflation rate to stabilize.

So, who benefits when interest rates are high? People with saving accounts may be able to get more bang for their buck due to the higher interest rate. However, not all banks raise interest on saving accounts, nor do they raise them at the same rate as the interest on loans.

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What inflation means for home loan interest rates

In raising interest rates, the RBA effectively raises the cost of homeownership. For example, if you have a variable rate mortgage, your rate will increase, and with it your payments. Even if you have a fixed rate mortgage, you face paying the newly raised rates once the variable stage begins.

Future homebuyers may also feel the effects. If you’re looking for a home, you may pause your search due to the higher rates, as the added cost may no longer fit in your home loan budget.

Additionally, if inflation continues unabated despite a round of interest rate hikes, then homeowners are being slammed with higher mortgage repayments while still having to cope with the costs of higher petrol and groceries.

Inflation and interest rates in Australia over time

As you can see from the below graph, the path for both the CPI and cash rate target is fairly similar. As prices increase, so do the interest rates, and vice versa.