Are skyrocketing interest rates really in Australia's best interests?

Analysis

The Reserve Bank of Australia (RBA) has kept interest rates on hold this month at 4.1%. But any reprieve could be short lived with the RBA Governor Philip Lowe warning that more rate hikes could be coming. Is this in the best interests of the country when many Australians are already feeling the pinch? UQ Business School's Deputy Head of School, Professor Shaun Bond, helps explain the role of the Reserve Bank and how decisions are made to balance the needs of the country and individuals.

Watch any news program or scan the headlines of a news website, and chances are you see the day’s economic news reported much like the latest sporting results.

Great attention is paid to whether the RBA has increased or decreased interest rates, whether the stock market is up or down, the current level of the Australian dollar, and other key measures related to unemployment and inflation. These stories make headlines because the way the economy is performing directly affects every Australian. The news today that official interest rates haven’t increased in July will be welcomed by many home owners.

Who sets interest rates in Australia and why?

The RBA has specific obligations to all Australians. It is required by legislation to manage monetary policy (interest rate policy) and the banking system in a way that is “…directed to the greatest advantage of the people of Australia and that the powers of the Bank ... will best contribute to: the stability of the currency of Australia; the maintenance of full employment in Australia; and the economic prosperity and welfare of the people of Australia.”

Why has the RBA continued to increase rates?

So, the RBA should be making decisions that support all Australians. Why then is the RBA raising rates, which leads to higher mortgage payments for homeowners, at a time when so many other costs are rising?

It is the challenge of the governor and the RBA board to make these decisions and balance the potentially conflicting needs of different groups in the economy. It is one of the reasons why their actions are closely watched and discussed in the media.

Interest rates are set with the goal of keeping inflation within a manageable range. Inflation is the rate at which the price of goods and services is changing in Australia. Anyone who shops for their household will know that inflation has been increasing. The price that we pay for food, petrol, gas and electricity, rent, airfares, school fees, haircuts, and a whole host of other purchases has been going up over the last 2 years.

The RBA, supported by evidence from around the world, shows that keeping inflation in the 2–3% range helps to meet their objectives and provides an environment to support the prosperity of Australians. However, at the moment, inflation is running around 7%, well above the RBA target range.

The last time inflation was this high was in the 1980s, which means that Australians under the age of 35 will not have previously experienced such high general price-level increases in their lifetime. The last 3 decades are generally viewed as being very prosperous for Australia and one of the key reasons for this is that inflation has been kept under control by the RBA.

Why is inflation so high at the moment?

There are many reasons behind the surge in inflation and an even greater variety of views about the best way to deal with these challenges. However, like many disruptions over the past 3 years, the global pandemic is often pinpointed as the catalyst for creating a perfect storm of events that sparked the rise in global inflation.

The pandemic saw massive stimulus to the economy by governments around the world. This stimulus often took the form of support payments to businesses and households to make up for the lost income caused by health restrictions. The RBA, along with central banks around the world, also cut interest rates to virtually zero to help offset the restrictive effects of the pandemic.

The combination of a high level of government spending, historically low interest rates, supply disruptions from pandemic-related restrictions, and the war in Ukraine have meant that the economy is running at a higher level of activity than normal capacity permits – that is, it's ‘overheating’. It is just like running an engine at too high speeds for too long: it overheats. The only way to cool it down is to tap the brakes to slow the speed.

How does the RBA slow the speed of the economy?

The most obvious way is by raising interest rates and we have seen the RBA aggressively do this since May 2022. Since this time, the cash target rate managed by the RBA has been raised by 4 percentage points – from 0.10% to 4.10%. This rate is central to the financial structure of the economy as it is the rate that banks lend to each other in the overnight market. It sets a benchmark and affects the cost of funds for banks which then flows through to the interest rates for other loans, such as home loans.

It should also be remembered that while these rate increases have been hard for borrowers, many retirees and others saving for retirement have benefited from these increases.

Will interest rates keep increasing?

Nobody has a crystal ball and can say for certain what the future holds, but the statement from the RBA in July is that inflation does seem to be moderating and spending by households is slowing.

The rate increases over the last year have clearly had an impact. We can’t rule out further rate increases, but the signs suggest we are getting close to the peak in rates.