Inflation and interest rates are inextricably linked in the Australian economy. When you hear news about rising inflation or the Reserve Bank of Australia (RBA) adjusting the cash rate, these events are directly connected. Understanding this relationship is crucial for anyone with a mortgage, savings account, or simply trying to make sense of economic news and its impact on household finances.

What is Inflation and How is it Measured?

Inflation refers to the general increase in prices of goods and services over time. When inflation rises, each dollar in your pocket buys less than it did before. In Australia, inflation is primarily measured by the Consumer Price Index (CPI), which tracks the price changes of a basket of goods and services that typical Australian households purchase.

The Australian Bureau of Statistics calculates the CPI quarterly, measuring price changes across categories including food, housing, transportation, health, education, and recreation. This comprehensive measure gives us the headline inflation rate that you hear reported in the news.

The RBA also pays close attention to underlying inflation measures like the trimmed mean and weighted median, which strip out volatile price movements to show the persistent trend in inflation. These measures help the central bank distinguish between temporary price spikes and genuine inflationary pressure in the economy.

The RBA's Inflation Target

The Reserve Bank of Australia aims to keep inflation within a target band of 2-3% per year, on average, over time. This target has been in place since the early 1990s and represents a sweet spot that balances economic growth with price stability.

Why not aim for zero inflation? A moderate level of inflation is actually considered healthy for an economy. It encourages spending and investment (since money loses value if just held as cash), gives the RBA room to cut rates during economic downturns, and allows for gradual adjustments in wages and prices across the economy.

When inflation strays too far from this target—either too high or too low—the RBA responds with monetary policy adjustments, primarily through changes to the cash rate.

How Interest Rates Control Inflation

Interest rates are the RBA's primary tool for managing inflation. The mechanism works through several channels that ultimately influence spending and saving behavior across the economy.

When inflation is too high, the RBA raises interest rates. Higher rates make borrowing more expensive, so households and businesses are less likely to take out loans for purchases. This reduces demand in the economy. At the same time, higher rates make saving more attractive, as deposits earn better returns. The combination of reduced borrowing and increased saving means less money chasing goods and services, which puts downward pressure on prices.

For mortgage holders, higher rates mean increased monthly repayments, leaving less money for discretionary spending. This reduced consumer spending is exactly what the RBA intends—it's the transmission mechanism that helps cool an overheating economy.

When inflation is too low (or the economy is sluggish), the RBA cuts interest rates. Lower rates make borrowing cheaper, encouraging households to take out mortgages, car loans, and other credit. Businesses find it more affordable to invest in expansion. With saving less rewarding, people are more inclined to spend. This increased economic activity helps push inflation back toward the target band.

The Lag Effect: Why Patience Matters

One crucial aspect of the inflation-interest rate relationship is timing. Changes to interest rates don't immediately affect inflation—there's typically a lag of 12-18 months before the full impact is felt in the economy.

This delay occurs because it takes time for rate changes to flow through to mortgage repayments (especially for those on fixed rates), influence business investment decisions, and ultimately show up in consumer prices. The lag makes the RBA's job challenging, as they must make decisions based on where they expect inflation to be in the future, not just where it is today.

This is why you'll often hear the RBA refer to forward-looking indicators and explain that they're acting to address future inflation pressures, not just current conditions. It's also why rapid, aggressive rate changes can be problematic—by the time their full effect is felt, economic conditions may have already shifted.

What This Means for Your Mortgage

Understanding the inflation-interest rate connection helps you anticipate potential changes to your mortgage costs. When inflation data comes in higher than expected, it increases the probability of rate rises. Conversely, low inflation readings suggest rates may stay steady or even fall.

For variable rate borrowers, the impact is direct and relatively quick. Banks typically pass on RBA rate changes within days or weeks, meaning your monthly repayments can fluctuate with each monetary policy decision. Use our loan repayment calculator to see how different rate scenarios would affect your repayments.

Fixed rate borrowers are shielded from rate increases during their fixed term, but they need to think ahead. If you're considering fixing your rate, understanding inflation trends can help you assess whether current fixed rates are likely to look attractive compared to where variable rates might head in the coming years.

Impact on Savings and Investments

The inflation-interest rate relationship affects savers too, though sometimes in counterintuitive ways. When rates rise to combat inflation, savings account and term deposit rates typically increase as well. However, you need to consider the real return—the interest rate minus inflation.

For example, if your savings account pays 4% interest but inflation is running at 5%, your real return is actually negative 1%. Your money is earning interest, but it's losing purchasing power faster than it's growing. This is why periods of high inflation can be challenging for savers even when nominal interest rates seem reasonable.

Understanding this relationship helps you make better decisions about where to put your money. In high-inflation environments, you might need higher-yielding investments to maintain your purchasing power, while in low-inflation periods, even modest interest rates can deliver positive real returns.

Current Economic Context

Following the global disruptions of recent years, inflation has been a significant concern for central banks worldwide, including the RBA. Supply chain disruptions, energy price volatility, and strong consumer demand have all contributed to inflation running above target levels in many countries.

The RBA has responded with a series of rate increases designed to bring inflation back to the 2-3% target band. These decisions involve difficult trade-offs—raising rates enough to cool inflation while trying to avoid pushing the economy into recession or causing unnecessary hardship for mortgage holders.

As a borrower or saver, staying informed about inflation trends helps you understand why rates are moving and what might come next. Watch for quarterly CPI releases and RBA meeting announcements to get a sense of the trajectory.

Conclusion

The relationship between inflation and interest rates is fundamental to understanding the Australian economy and your personal finances. When inflation rises, expect interest rates to follow as the RBA works to bring prices under control. When inflation is subdued, rates are likely to remain steady or fall.

For mortgage holders, this knowledge helps you plan for potential rate changes and make informed decisions about fixed versus variable loans. For savers, it highlights the importance of looking beyond nominal rates to consider real returns after inflation. Use our loan repayment calculator to model how different interest rate scenarios might affect your mortgage, helping you prepare for whatever economic conditions lie ahead.