How Does Raising Interest Rates Control Inflation?


When the Reserve Bank of Australia raises interest rates, it’s big news.

For the fifth time in a row, the RBA announced on Tuesday an increase to the official cash interest rate by 0.5% to help fight inflation and keep price growth under control. The 2.25% in interest rate increases since May are the RBA’s sharpest rate rises since 1994.

Why are interest rates rising so rapidly?

After a few decades of relatively stable inflation, consumer prices have been sharply increasing in 2022. A year ago, the Reserve Bank of Australia was forecasting that inflation for 2022 would be around 1.75%.

The latest Australian Bureau of Statistics (ABS) CPI figures reported that the annual Australian inflation rate is 6.1%, which is the highest recorded since 1990. Now, Australians are facing the prospect of CPI inflation reaching a peak of 7.75%, or more.

This is a very big forecasting miss. Even according to Philip Lowe, RBA Governor at the Inflation and the Monetary Policy Framework speech on 8th September 2022:

Forecast misses of this scale should lead to soul-searching by forecasters and they certainly have at the RBA. It is important that we learn from this and improve our understanding of the inflation process.

The RBA has responded to inflation in the same way as other central banks have around the world: by raising interest rates.

Why is high inflation so bad?

When inflation is high, it eats into household budgets and can lead to higher mortgage repayments and other household debt repayments, which can in turn lead to decreased consumer spending and confidence.

As Philip Lowe put it this week:

High inflation is a scourge. It damages our standard of living, creates additional uncertainty for households and businesses, erodes the value of people’s savings and adds to inequality. And without price stability, it is not possible to achieve a sustained period of low unemployment. It is important, therefore, that this current surge in inflation is only temporary and that we once again return to the 2 to 3 per cent range.

How do interest rates affect inflation?

Inflation is determined by many factors including economic growth, unemployment, wages growth and money supply. To control inflation, the RBA uses monetary policy tools including changing the cash rate –which is what has happened on Tuesday.

Banks borrow money, sometimes from each other, to make loans to consumers and businesses. So when the RBA raises its cash rate, it raises the cost of borrowing for banks that need funds to lend out. Banks naturally pass on these higher costs to consumers and businesses. A rise in interest rates makes borrowing money more expensive and this usually leads to slower economic growth and increased unemployment as companies cut costs by shedding jobs.

When interest rates are lower and more people are borrowing money cheaply, there is a greater supply of money in the economy. When the RBA raises interest rates, it means the money supply circulating will start to decrease.

How high will the RBA raise interest rates to combat inflation?

The short answer; as high as necessary.

The Board expects that further increases in interest rates will be required over the months ahead… But how high interest rates need to go and how quickly we get there will be guided by the incoming data and the evolving outlook for inflation and the labour market.

Inflation is about to be reported monthly

On 26 October 2022, the ABS will commence publication of a monthly CPI indicator.

Until then Australia has been the only member of the G20 leading industrial nations not to provide monthly CPI updates, and one of only two members of the Organisation for Economic Co-operation and Development, the other being New Zealand.

With the RBA meeting monthly, it makes much more sense to release CPI information monthly, rather than the usual 3 month lag.

Watch this space.



Less Debt More Life™

You work hard for your money – imagine your peace of mind knowing your money is working hard for you. Our Mortgage Action Plan delivers guaranteed results and allows you to start living the life you deserve.


Join our Facebook Community

To learn how everyday Australians are ‘beating the banks’ by eliminating debts and achieving financial independence.