The Reserve Bank of Australia has announced a Melbourne Cup Day rate hike, lifting the cash rate target to 4.35%, marking the 12th increase since the pandemic and the highest interest rate in 12 years.
What prompted the RBA’s decision? The answer in a single word is inflation.
The Australian Bureau of Statistics released its latest inflation figures two weeks ago, which revealed a substantial 1.2% rise in prices throughout the Australian economy in a single quarter – far exceeding everyone’s expectations.
Moreover this inflationary pressure was not isolated to any single cause, such as oil price shock from the Middle East or a cyclone devastating crops in Queensland; it was pervasive across nearly all sectors of the economy and every state and territory. Prices are rising – well above the RBA’s target rate for inflation – which forced the RBA to act with the one blunt tool it has: higher interest rates.
Solidifying this decision is the current robust state of the economy. With unemployment holding at an extraordinarily low 3.6% – a figure any treasurer of the past 20 years would have envied – and an uptick in retail spending, it appears that despite the significant rate increases over the past 18 months, economic growth and consumer spending has remained resilient.
How does a higher interest rate address inflation? For most homeowners the direct effect is obvious: higher mortgage payments and so less disposable income. By forcing these households to cut back their spending the RBA’s interest rate hike will lower demand for goods and services across the economy which, in turn, should help ease inflationary pressures.
However, higher interest rates also influence the economy in myriad other ways. For example a higher interest rate means a stronger Australian dollar.
In May the RBA surprised everyone by hiking interest rates by 0.25% which caused the Australian dollar to immediately increase in value by 1%. This appreciation may not seem significant, but it means the price of every good that Australia imports soon became 1% cheaper. Cheaper cars, cheaper petrol, cheaper medicine, and even cheaper iPhones. These are all goods that Australian households use on a daily basis.
Tuesday’s interest rate hike was largely expected, and thus already priced into today’s exchange rate, but it will still help keep the cost of imported goods down by keeping the value of the Australian dollar up.
The recent interest rate increase also sends a signal to businesses and the government to reassess their expenditure. The treasurer, Jim Chalmers, has already indicated the government is going to scrutinise its infrastructure spending, motivated not only by a prudent desire not to waste money on dud projects, but also by the rising costs of government borrowing, which is now over 4%. Businesses across Australia will be doing the same as they grapple with a higher cost of borrowing when pencilling out their investment plans for the coming year.
Before the RBA’s meeting, there was some concern that it might pause rate adjustments due to political pressure. However, this was always a needless worry.
For starters, both the RBA and the government know that the only way to bring inflation down in the medium term is through tighter monetary policy. Moreover, the RBA has a long track record of increasing interest rates when needed, even during election campaigns.
Treasurers of all sides of the political fence know the RBA has an important job to do and they do that job free of political interference. As the recent review of the Reserve Bank of Australia made clear, despite the close cooperation between the Treasury and the Reserve Bank, in recent decades there has never been an instance of a treasurer interfering with the RBA board, even though the Treasury secretary is a member of it.
With one more RBA meeting left in 2023 the looming question from many Australian households is whether this increase will be the final one or if the RBA will end the year with another interest rate hike.
In its statement on Tuesday the RBA board said that future decisions will hinge on “the data and the evolving assessment of risks”.
This is RBA-speak for the upcoming data on wage growth which will be published next week. If the ABS reports that wage growth remains strong or surprises us and surges upwards like inflation, we may see yet another rate hike from the RBA before the year’s end – just in time for Christmas.
Dr Isaac Gross is a lecturer of economics at Monash University
