Why are interest rates going up? What does inflation have to do with the Reserve Bank’s decision? 

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You’ve probably heard the Reserve Bank is likely to increase official interest rates when it meets again this afternoon.

Economists are predicting another 0.5 percentage point increase (although many got the exact figure wrong last time)!

But do you understand why?

All this talk of cash rates, inflation, wages growth — it can make your head spin!

So, let’s break it down.

Why is the rate going up?

It’s mostly an attempt to curb inflation.

You will have noticed prices have been going up – whether it’s food, fuel or materials.

Inflation is usually measured by the Consumer Price Index, which provides data about price increases for households on average (by comparing a basket of goods).

And that number is currently 5.1 per cent.

“The RBA will adjust interest rates to fasten or slow down the economy to achieve its inflation target of 2-3 per cent over the medium term,” said Impact Economics’ lead economist, Angela Jackson.

“If nothing else changes, higher interest rates lower spending and increase savings in the economy.”

And why is inflation rising?

There are a few reasons.

“One is we’ve had a lot of COVID disruptions,” explains economist Nicki Hutley.

“We haven’t had enough supply at a time when demand from goods is very strong.

“On top of that, the war in Ukraine has sent energy prices soaring. In Australia, we’ve also had flooding, which impacts agricultural prices.”

Reserve Bank Governor Philip Lowe says inflation could reach up to 7 per cent by the end of the year.

He thinks it will begin easing next year after a series of interest rate hikes.

What does the Reserve Bank consider when it makes decisions?

The Reserve Bank’s job is to help manage the Australian economy, explains Ms Jackson.

It considers all sorts of factors like inflation, unemployment, wages growth, pubic and private sector spending.

The biggest tool it has to make changes is the official cash rate (which influences borrowing costs for the banks, and in turn, us).

But, it’s a clunky tool.

“Using interest rates is a bit like steering the Titanic,” said Ms Hutley.

“It’s slow and takes a lot of effort to be precise. There’s a risk you go too hard and too fast and hit the iceberg. And the iceberg is a recession,” she said.

How high could rates go?

Reserve Bank Governor Philip Lowe has warned rates could get to 2.5 per cent at some stage (but some economists say it may go even further).

But it’s important to remember interest rates have been at record lows.

“Because of unusual conditions created with COVID, there was always going to be some rise in interest rates to get it back to normal levels,” said Ms Hutley.

“Now inflation has gone too far, so rates not only need to get back up to normal levels, but even further to slow the economy a bit.”

What does it mean for me?

Unfortunately, it’s not great news in the short term.

As well as paying more to borrow money, the stuff we buy will be more expensive.

“You’ve got prices for most goods rising significantly faster than wages, so effectively you’ve got less money in your pocket to be able to spend,” warns Nicki Hutley.

“The average person is going to have a difficult year ahead.”

ABC

(Original ABC Article)