Interest rates up with more hikes possible

The nation’s benchmark interest rate has been lifted 50 basis points by the central bank today to be 1.85 per cent.

The move is the fourth consecutive increase in the Official Cash Rate by the Reserve Bank of Australia, with the rate hitting its highest level since 2016.

According to the RBA’s data, the bank had never raised rates at four consecutive meetings since the beginning of the inflation targeting era in the early 1990s.

It follows last week’s news of the continued acceleration of inflation, which was 6.1 per cent in the year to June, less than many forecasters had been predicting.

In Perth, inflation had been 7.4 per cent for the 12 months.

The RBA’s move also follows a hike by the United States’ Federal Reserve Bank, with the Fed Funds Rate up 75 basis points to a target band of 2.25 per cent to 2.5 per cent.

RBA governor Philip Lowe said the outlook for global growth had softened.

“The board places a high priority on the return of inflation to the 2–3 per cent range over time, while keeping the economy on an even keel,” Mr Lowe said. 

“The path to achieve this balance is a narrow one and clouded in uncertainty, not least because of global developments. 

“The outlook for global economic growth has been downgraded due to pressures on real incomes from higher inflation, the tightening of monetary policy in most countries, Russia's invasion of Ukraine and the COVID containment measures in China.”

But the bank said "normalisation" of rates would continue in months ahead.

“The size and timing of future interest rate increases will be guided by the incoming data and the Board's assessment of the outlook for inflation and the labour market,” Mr Lowe said.

“The board is committed to doing what is necessary to ensure that inflation in Australia returns to target over time.”

What is the cash rate?

Banks use an exchange settlement mechanism through the RBA to net out transfers between customers at the end of each day.

The RBA sets the official cash rate, which determines the interest rate charged between banks for overnight loans in this system.

That becomes the benchmark for other interest rates because it impacts the borrowing costs for a bank.

Banks have other potential short term borrowing methods, including 30 day, 60 day, or 90 day bills, but the rates on these closely follow expected cash rate movements.

Any differential between the interest rates on those bills and the forecast cash rate would advantage one side of a transaction, and so competition incentivises banks to keep the two rates close.

There are a few key mechanisms through which interest rates impact the economy.

The most well-known is that higher interest rates raise repayment costs for mortgages and other borrowings, which reduce cash available to be spent.

A 50 basis point rise would cost a homeowner with a $500,000 mortgage about $166 more per month, according to the Commonwealth Bank’s calculator.

The second impact is that changing rates changes investment decisions.

Businesses will need to be more careful about borrowing to fund new equipment or expansions as rates go up.

It changes the calculations for financing projects.

That leads to lower investment spending.

With the potential for bigger interest bills, new buyers will also pay less for a new home, slowing growth in house prices, or even leading to the drops experienced in east coast cities in recent months.

Lower house prices make consumers feel less wealthy and reduce spending.

Then there’s an international effect.

Investors will tend to move savings towards countries with higher interest rates, so a lift in the cash rate should generally create an inflow of investment into Australia.

That pushes up the exchange rate, making exports slightly less competitive and making imports cheaper.

This leads to a further reduction in spending in the local economy.

All of that, the RBA hopes, will help rebalance demand and supply to get inflation under control.