Interest rates, inflation, the RBA and how it all works (2024)

FAQs

How do inflation and interest rates work? ›

When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down. When inflation is too low, the Federal Reserve typically lowers interest rates to stimulate the economy and move inflation higher.

Australia's inflation target is to keep annual consumer price inflation between 2 and 3 per cent. The particular measure of consumer price inflation is the percentage change in the Consumer Price Index (CPI).

Smoothing the business cycle

On the other hand, when the economy grows too quickly because of excessively strong demand, the Reserve Bank can tighten monetary policy, such as by raising the cash rate target to dampen economic activity and contain inflation.

The Bank conducts the nation's monetary policy and issues its currency. It seeks to foster financial system stability and promotes the safety and efficiency of the payments system. It also offers banking services to government. The Bank is a body corporate wholly owned by the Commonwealth of Australia.

When the central bank increases interest rates, borrowing becomes more expensive. In this environment, both consumers and businesses might think twice about taking out loans for major purchases or investments. This slows down spending, typically lowering overall demand and hopefully reducing inflation.

When confronting inflation, governments may pursue a contractionary monetary policy to reduce the money supply within an economy. The U.S. Federal Reserve (the Fed) implements contractionary monetary policy through higher interest rates and open market operations.

High inflation outcomes in Australia reflect a range of developments, including: supply issues related to the war in Ukraine; other global supply disruptions resulting from the COVID-19 pandemic; and domestic supply disruptions from poor weather.

As the labor market tightened during 2021 and 2022, core inflation rose as the ratio of job vacancies to unemployment increased. This ratio is used to measure wage pressures that then pass through to the prices for goods and services.

The Fed has stated on numerous occasions that its goal is an annual inflation rate of 2%.

Banks make money from the interest they charge on loans. As interest rates rise, banks can often charge a higher interest rate on loans and credit cards compared with the rates they have to pay savings and other interest bearing accounts.

Why do banks make more money when interest rates rise? ›

We can do this because Bank Rate is the interest we pay to banks, building societies and financial institutions who hold reserve accounts with us. So when we raise Bank Rate, banks will usually increase how much they charge on loans and the interest they offer on savings.

The Federal Reserve sets interest rates

The Federal Reserve, specifically the Federal Open Market Committee (FOMC), adjusts the Federal Funds Rate—also called the target interest rate. The change is reflected in basis points, a financial term for 1/100th of a percent.

INFLATION? In 1989, the Reserve Bank was formally given the task of using monetary policy to control inflation. Since 1999, the Bank has done so by setting the 'Official Cash Rate' (OCR) – in other words, by setting the wholesale price of borrowed money.

Inflation targeting is straightforward, at least in theory. The central bank forecasts the future path of inflation and compares it with the target inflation rate (the rate the government believes is appropriate for the economy).

The South African Reserve Bank (SARB) is controlled by the South African Reserve Bank Act, with its shares privately owned and managed by a board of 14 directors, seven of whom, including the governor and three deputy governors, are appointed by the President of South Africa.

It is the actual rate paid. For example, the interest rate paid to you on a savings account is a nominal interest rate. A “real interest rate” is an interest rate that has been adjusted for inflation. To calculate a real interest rate, you subtract the inflation rate from the nominal interest rate.

Do Interest Rates Rise or Fall in a Recession? Interest rates usually fall during a recession. Historically, the economy typically grows until interest rates are hiked to cool down price inflation and the soaring cost of living. Often, this results in a recession and a return to low interest rates to stimulate growth.

If aggregate supply falls but aggregate demand remains unchanged, there is upward pressure on prices and inflation – that is, inflation is 'pushed' higher. An increase in the price of domestic or imported inputs (such as oil or raw materials) pushes up production costs.

In an inflationary environment, unevenly rising prices inevitably reduce the purchasing power of some consumers, and this erosion of real income is the single biggest cost of inflation. Inflation can also distort purchasing power over time for recipients and payers of fixed interest rates.