Why do interest rates rise with inflation?

An increase in inflation is often associated with an increase in interest rates that can impact on the cost of home loans and other credit products. But although the two are linked, the relationship is complex, and there can be more to the story than meets the eye so this guide will explore why interest rates rise with inflation.

Inflation is the term used to describe an increase in the prices of goods and services in a particular economy. The consumer price index (CPI) measures change in price of a specific “basket” of goods and services that are commonly relied on by the average household. In Australia, what goes into the “basket” and the measurement of the CPI is overseen by the Australian Bureau of Statistics (ABS). Changes in CPI are used as an indicator of inflation (and its opposite, deflation). When inflation occurs, it can affect not just the goods and services we purchase in our everyday life, but also the total cost of bank products, such as personal loans, credit cards and home loans.

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The Reserve Bank of Australia (RBA) monitors and acts to control inflation because significant movements in the inflation rate impacts the economy by changing the way we, as consumers, spend our money. Changing official interest rates is one way the RBA can help to influence inflation.

The impacts can be complex but here is an overview:

• As inflation increases, the prices of goods and services rise
• If prices rise more than wages, people can’t buy as much as they used to, so they cut discretionary spending (spending on anything that isn’t essential)
• As inflation continues to rise, the lowest income earners become unable to afford basic necessities and can slip into poverty
• As people cut spending, businesses lose income, which makes it harder for them to buy more goods and raw materials
• Businesses then either need to raise prices, decrease costs (often by letting staff go), or stop operating
• When businesses raise their prices, inflation goes up further, however, when businesses go bust or hand out redundancies, inflation may slow
• Interest rates are, effectively, the “cost of money”. If it is more expensive to borrow money, the economy as a whole has less access to money, spends less, lowering demand and therefore lowering prices and inflation.

Within this theoretical framework, the RBA tries to keep inflation to around 2–3 per cent. Higher than this range, prices could get out of control. Lower than this range, economic growth can slow too much and investment in the economy also slows. One of the RBA’s main tools for controlling inflation is the cash rate, which is strongly tied to the interest rates banks and other lenders charge and offer.

If inflation is too low and employment and economic growth are weak, the RBA might reduce the official cash rate. If inflation is too high, the RBA might increase the official cash rate.

The cash rate affects other interest rates, such as money market rates and bond yields. It’s also the price banks pay for overnight loans (so it’s what they pay when they borrow money). As banks borrow money in order to help fund the loans they give out, the cash rate impacts bank borrowing costs, and so is one of the primary factors that influence the interest rates banks set for their savings accounts and loans.

It’s important to note, however, that the cash rate is by no means the only condition that impacts lender interest rates. But in general, if the RBA raises rates, there’s a good chance banks and other lenders will increase their interest rates as well. And if the RBA reduces the cash rate, there’s also a good chance that lenders will lower their interest rates.

As an example of how this can work, when interest rates fall, people with loans, especially expensive, long-term ones like home loans, have more money left over for discretionary spending. So, they are more likely to go shopping, buying more and therefore increasing demand for a variety of products and services. Businesses respond by producing more goods, and often need to employ more people to help make and sell those goods. They may also hire more people, so they can deliver more services. This increases both economic activity and employment. When businesses can’t keep up with demand, they raise their prices, and this leads to inflation.

Depending on your situation, inflation could affect you in several ways. Or it might have little impact on you other than to reduce the value of your money. Some of the common impacts of inflation and rising interest rates can include:

Regardless of the kind of interest rate you have, if your income increases, your debt burden will decrease as the value of our currency decreases. However, in times of rising inflation real wages may experience a reduction. Real wages is income expressed in terms of purchasing power as opposed to actual money received. A reduction in real wages, due to inflation, can make it harder to manage your debt and other expenses because your income is no longer worth what is used to be.

If you’re trying to get into the housing market, an increase in interest rates can reduce your borrowing power. As a result, you may not be able to afford a home of the same quality. However, rising home loan interest rates can also reduce demand for housing (as borrowing money becomes less attractive), which may help to reduce house prices. In that case, your borrowing power may reduce, but you might still be able to afford the same home quality due to a reduction or steadying in house prices.

If you’re trying to sell a property, you might find demand for housing weakens, which could reduce the final price you can get for your property.

If you own an investment property, your rental yield may be impacted by inflation and changing interest rates. Any changes will depend on complex local responses to the changing economic conditions.

If you’d like to start investing, you may face less competition in times of inflation.

If you have money in a savings account, RBA decisions to increase interest rates could mean you earn more interest on your savings. In times of high inflation this is often mitigated by the increase in the costs of common goods and services.

It’s important to note that the potential impacts and consequences outlined above are based on generalisations, and any given area may buck the trend.