This snippet is from one of our previous episodes: What do Inflation, Interest Rates & Broccoli have to do with Property?!

Remember when a kilo of broccoli set you back eleven dollars?

It was one of those moments that seemed to sum up the cost-of-living squeeze perfectly. Groceries were getting more expensive, petrol prices were climbing, household budgets were being stretched… and at the same time, interest rates were going up too.

Which raised a pretty fair question: If people are already paying more for the essentials, why would the Reserve Bank make things even harder by increasing interest rates?

That’s exactly what listener Jess asked Ben and Bryce in this week’s Throwback Tuesday snippet.

First, why inflation matters at all

At its simplest, inflation means that your money buys you less.

If prices rise faster than your income, the same pay packet doesn’t stretch as far as it used to.

The obvious comeback is, well, just pay everyone more. But that’s not how it works in practice. Businesses can’t automatically lift wages, and plenty of them run on very tight margins. Push hard enough and some of them break — and when businesses break, unemployment rises. That’s the vicious cycle central banks are trying to avoid.

Which is why, in Australia, the RBA aims to keep inflation between 2% and 3% over time. It’s not about eliminating inflation altogether. The aim is to provide the kind of price stability that supports sustainable economic growth over time — rather than allowing inflation to become entrenched and contributing to bigger boom-and-bust cycles.

Ben and Bryce point back to Australia’s experience in the early 1990s and the infamous “recession we had to have”. Bryce, who was a teenager at the time, remembers exactly how it felt for a family at the lower end of middle class. Not pleasant. And the damage to the national psyche lasted longer than the numbers did.

The bigger risk: inflation starts changing our behaviour

This is where the conversation moves from imported inflation to something potentially more difficult to control.

Imagine businesses start seeing prices rise everywhere. Eventually, some may begin thinking: Everyone else is charging more. Maybe customers will accept me charging more too.

Employees then see their cost of living rising and understandably ask for higher wages. Businesses face higher wage costs, so they increase their prices again. Consumers begin expecting prices to rise, so their behaviour changes too.

And once people expect high inflation, it can become much harder to bring back under control. That’s the inflation “genie” Ben talks about putting back in the bottle.

So where do interest rates come into it?

Higher interest rates are essentially designed to reduce demand.

When borrowing becomes more expensive:

  • mortgage repayments can increase;
  • households generally have less surplus cash available;
  • new borrowing becomes less attractive;
  • businesses may think twice about investing or expanding; and
  • consumers become more selective about what they’re willing to pay for.

That last point is particularly important.

The Reserve Bank wants businesses to start wondering: “Will customers actually pay this higher price?”

If enough consumers pull back, businesses have less ability to continually pass through price increases. And over time, weaker demand can help take some heat out of inflation.

That doesn’t mean higher rates can solve every cause of inflation. They can’t end a war, repair a supply chain or stop a flood. But they can influence how much demand exists in the economy and how inflationary expectations develop from there.

The adjustment is painful

Bryce also makes an important point about human behaviour.

Nobody enjoys adjusting to having less.

For households with a mortgage, that can mean making some uncomfortable decisions about discretionary spending to continue meeting repayments and keeping the family budget in balance.

It also means the impact isn’t felt equally.

Higher prices for essentials already tend to hurt lower-income households the most because necessities consume a larger share of their income. Add rising borrowing costs into the equation and that pressure can become even greater.

That’s what makes monetary policy such a difficult balancing act.

So… why raise rates when everything already costs more?

Because the Reserve Bank isn’t simply trying to make broccoli cheaper.

It’s trying to stop an initial burst of inflation from spreading throughout the economy and becoming entrenched in the way businesses set prices, workers negotiate wages and consumers behave.

Higher rates reduce spending power. Lower spending creates less competition for goods and services. Less demand makes it harder for businesses to keep raising prices. And eventually, the aim is to bring inflation back towards a more sustainable level.

None of that makes higher grocery bills or mortgage repayments any less painful.

But it explains why policymakers can look at an economy where households are already feeling squeezed… and decide that applying additional pressure now may help prevent a much bigger inflation problem later.

Before you accept your current rate as “just what it is”…

It may be worth seeing how it stacks up. Our Mortgage Broking team can review your current lending and help you decide whether staying put or making a change makes sense.

Request your free review.

__________________

If You Enjoyed Why Do Interest Rates Rise When Prices Are Already High? You Might Also Like: