Why do interest rates rise with inflation?

The latest higher than expected inflation figures have led to calls for a hike in interest rates. So what’s the connection between the two, and why is it hoped a hike in interest rates will lead to any fall in inflation?

The link between interest rates and inflation is the battle waged by the Reserve Bank of Australia (RBA) to keep the costs of goods and services at a level people can afford. The challenge is to make sure there’s a balance between supply and demand.

One way the RBA can help control that is through setting the official cash rate, which is the interest rate banks pay to borrow funds. It’s the base figure banks use to then set their own interest rates you pay to borrow from them.

Read more: Inflation spike prompts calls for early interest rate rise

The aim of the RBA is to keep inflation in the 2–3% range if possible. If inflation goes outside that range then the RBA can use changes in the cash rate in an attempt to regain control of inflation.

So what impact does a change in inflation have on interest rates?

Inflation vs interest rates

The current economic thinking is that if interest rates are low it makes borrowing relatively cheap, so people have easy access to money to spend on things such as a house or car, or other goods and services.

But John Quiggin, a Professor in Economics at The University of Queensland, told Canstar that means sellers may raise their prices due to increased demand, which  can lead to a rise in the Consumer Price Index (CPI) – hence a rise in inflation. CPI is a measure of the average change over time in the prices paid for a fixed basket of goods and services, as measured by the Australian Bureau of Statistics.

Prof Quiggin said if the RBA raised the cash rate, then banks and other lenders would traditionally raise their lending rates and that would make borrowing more expensive.

The thinking then is that if borrowing is more expensive, people would be more reluctant to spend – reducing demand and putting pressure on sellers to make prices more competitive. More competition should mean fewer price hikes on goods that make up the CPI, and hence lower inflation.

Alex Ballantyne, a Senior Associate in Grattan Institute’s Economic Policy Program, told Canstar the RBA’s challenge was then to set the cash rate at a level to try to manage demand.

“When the economy overheats – demand outstrips the supply of goods and services – inflation increases,” he said.

“In this circumstance, the Reserve Bank would try to cool the economy by raising interest rates.”

Will higher interest rates bring down inflation?

Interest rates can also affect demand in other ways.

“A familiar example is people who have a mortgage with a variable rate,” Mr Ballantyne told Canstar.

“An increase in their mortgage interest rate will increase their monthly repayments, which means they have less money left over to spend.”

The challenge here for the RBA is to not raise the cash rate so high it leaves people with difficulties in repaying their loans. For example, mortgage stress is when a household finds it difficult to pay their bills and cover their home loan repayments.

Read more: What is mortgage stress?

Professor David Orsmond, from the Economics Department at Macquarie University and a former Deputy Head of Departments at the RBA, told Canstar that’s something all central banks consider carefully when raising interest rates.

A large gap between interest rates and CPI wouldn’t necessarily see any sudden large increase in the cash rate, he said. The RBA would prefer to see CPI return to that 2–3% target on average over a long period of time.

The aim here then is to set the cash rate at a level where supply of any goods and services can meet demand.

“That’s what keeps inflation steady,” he said.

Cover image source: Andrey_Popov/Shutterstock.com