Source: The Conversation (Au and NZ)
A fifth interest rate hike by the Reserve Bank of Australia next week is now seen as likely by financial markets.
Whether the rate rise happens then, or at a future meeting, most of the media focus will be on the higher cost of mortgages.
But that’s just one of the ways higher rates dampen demand across the economy and help bring down inflation. Let’s look at some of those other avenues.
Why is the RBA raising rates?
Inflation has been stubbornly above the RBA’s target range of 2-3% for most of the past five years.
Data this week showed annual inflation has continued to rise, up to 4.3% in September from 4.0% in August. While the RBA’s favoured measure of underlying inflation was 3.7% in the September quarter, this, too, remains well above the central bank’s target.
Read more:
Inflation jumps to 4.3%, adding to pressure for RBA rate rise next week
RBA officials have been increasingly vocal about the need to bring down inflation. Deputy Governor Andrew Hauser warned recently that “the inflation outlook looks materially worse than we projected in the August report”.
Hauser was also worried that an increasing share of businesses are losing confidence in the central bank’s commitment to the inflation target. He called it the “central banker’s nightmare”.
Another RBA official, Assistant Governor Sarah Hunter, even went on 60 Minutes to explain the bank’s approach. She emphasised: “higher interest rates will work.”
Raising interest rates to slow the economy is how the RBA lowers inflation. Yet many people — perhaps a majority — are sceptical about this.
How does an interest rate rise help reduce inflation?
If the RBA does raise interest rates again, most of the focus will be on the impact on the one third of households with a mortgage, and particularly those in cities with the highest house prices.
Higher mortgage payments will leave these households with less money to spend on other things. This is known as the “cash flow” effect. It attracts attention as it is very tangible.
But this is only one channel, and maybe not the largest. It is also partially offset by some households, such as retirees, who benefit from higher interest on their savings.
The other ways that interest rates work, which affect the broader community rather than just households with mortgages, are:
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Higher interest rates make saving more attractive, which reduces spending.
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Higher borrowing costs flow through to all forms of debt. It makes borrowing by consumers to buy cars, furniture and whitegoods less attractive, deferring spending on these items. Companies facing higher borrowing costs may undertake fewer investment projects.
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Higher interest rates also tend to lower the value of assets, such as shares and houses. In the first half of 2026, house prices have fallen by 5% in Sydney and Melbourne. This makes households feel less wealthy and less likely to spend.
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Higher interest rates can also push up the value of the Australian dollar. A higher return on Australian assets makes them more attractive to overseas investors. Since the RBA started raising interest rates in February, the official cash rate has increased by 0.75% more than the equivalent in the United States. And thus far this year, the Australian dollar has appreciated from 67 to 70 US cents, although it is still below its high of 72 US cents.
The Australian dollar has also appreciated against many other currencies. The trade-weighted index, which measures the Aussie dollar against a basket of currencies, is at 65, up from around 60 during 2025.
A stronger dollar makes imports (including petrol) less expensive for Australian consumers, directly lowering prices.
A stronger Australian dollar can also weaken domestic economic activity because people may buy cheaper imports over locally made goods. Less demand for locally made goods means less money going into local manufacturers and jobs.
How big is the impact?
The RBA has done modelling that shows the peak effect of a rate move on economic activity and inflation occurs around one to two years after the rate change.
The models suggest real gross domestic product (GDP) could be 0.4% to 0.5% lower, and inflation 0.1 to 0.2% lower, than otherwise following a 1% interest rate hike.
What are the most important channels?
Some recent RBA research suggests the cash flow channel (via mortgages) “plays a relatively small role […] instead, the exchange rate is an important channel”.
RBA Governor Michele Bullock recently commented that “the most important channel is the exchange rate channel”. Hauser has gone further, calling the exchange rate channel “by far the most important in Australia”.
Because the impacts on the exchange rate are less visible to households, they also receive less attention. But they are still helping to slow the economy, and combat inflation.
It’s worth noting that mortgages in the US and other countries are fixed and priced off long-term interest rates, not the central bank’s official rate. And yet, as Bullock pointed out, “we know monetary policy works overseas”.
Higher interest rates have damaging side effects
One of the ways in which higher interest rates slow the economy is by deterring, or deferring, some business investment.
Unfortunately, that could also be making Australia’s productivity performance worse, because business investment to boost productivity has been weak in recent years.
As higher interest rates slow the economy, unemployment rises. Some people lose their jobs and those joining the labour force find it harder to get a job. We’ve already seen the unemployment rate rise from 4.3% in February to 4.7% in September.
The Reserve Bank will be hoping it can get inflation back within its target band fairly quickly so that interest rates do not have to stay higher for too long.
Read more:
What exactly is inflation, and are interest rates the only option for dealing with it?
John Hawkins was formerly a senior economist at the Reserve Bank.
Original source: https://analysis1.mil-osi.com/2026/10/29/mortgage-holders-arent-alone-in-paying-for-rate-hikes-heres-how-the-rba-spreads-the-pain/