High inflation causes interest rates to rise. Politicians don’t like that. But it’s all you need to know
Most Australians think rate rises make inflation worse. The RBA knows this — and it changes what rate rises can actually do.
A new RBA survey of 9,000 Australians has found that only one in four people correctly understands that higher interest rates reduce inflation. More than half believe the opposite: that rate rises make inflation worse. That is not a minor misunderstanding of a technical detail. It is a misunderstanding of the central mechanism through which Australia's most powerful economic institution operates, at the precise moment that institution is using that mechanism aggressively.
The mechanism works through more channels than the mortgage headline suggests
The confusion is understandable. Higher interest rates do make some things more expensive. Mortgage repayments go up. Business borrowing costs rise. If you are a renter whose landlord has a variable-rate loan, the rate rise lands on you too, even though you own nothing. The mechanism that connects this pain to lower prices at the supermarket is not obvious. It requires a small leap of economic logic that nobody is born knowing.
Here is the leap. Inflation is, at its core, too much money chasing too few goods. The RBA's job is to make the chasing stop. Higher interest rates do that through several channels simultaneously. The one that gets the most coverage is the mortgage channel: households carrying a mortgage, roughly one in three, have less money left after repayments and spend less. But that is only the beginning. Higher rates make saving more attractive, which pulls money out of circulation. They raise borrowing costs on car loans, furniture credit, and business investment, deferring spending. They tend to push down asset prices, making households who hold shares or property feel less wealthy and therefore less inclined to spend. And they typically push up the value of the Australian dollar, making imports cheaper and putting a ceiling on domestic prices that compete with them.
All of these channels work in the same direction: less demand, which gives inflation less fuel. The effect is slow and blunt, which is why the RBA's critics have a point when they note that rate rises hit mortgage holders long before they hit inflation. We have covered the distributional unevenness of that burden before. But the mechanism itself is not in dispute among economists. Higher rates do reduce inflation. The survey finding is not evidence that the theory is wrong. It is evidence that the theory has never been explained well enough for most people to grasp it.
Misunderstanding the mechanism breaks the mechanism
The stakes of that explanation gap are higher than they might appear. Inflation is not only a product of what prices currently are. It is partly a product of what people expect prices to be. If workers expect inflation to stay high, they bargain for higher wages. If businesses expect input costs to keep rising, they raise prices pre-emptively. If consumers expect the price of a refrigerator to be higher next month, they buy it now. Each of these behaviours is individually rational and collectively self-fulfilling. The RBA is not just raising rates to reduce spending directly. It is raising rates to signal that it will do whatever is necessary to bring inflation down, anchoring expectations so that the spiral does not take hold.
If more than half of Australians believe rate rises make inflation worse, then the signalling function of rate rises is partially broken. The medicine is being taken as evidence the patient is deteriorating.
That is why the survey result is, in the RBA Governor's own words, a problem. If more than half of Australians believe rate rises make inflation worse, then the signalling function of rate rises is partially broken. The medicine is being taken as evidence the patient is deteriorating.
Politicians who reach for simple explanations are making the problem worse
The political noise around all of this is worth cutting through briefly. The Opposition has run a consistent line that government spending caused this inflation and that every rate rise is therefore the government's direct fault. The claim is not without foundation, fiscal policy and monetary policy interact, and spending does affect demand. But the Opposition's version collapses the entire complexity of a global inflationary episode, supply chains, energy prices, post-pandemic demand surges, into a single domestic political cause. The survey data suggests the public is already inclined to reach for simple explanations. Politicians who reinforce that instinct rather than complicate it are not helping Australians understand the economy they live in.
The RBA, for its part, acknowledges it needs to communicate better. Bullock said directly this week that the bank needs to "do a better job of getting out there and explaining to people in simple terms what is going on." That is an honest admission. An institution that wields this much power over household finances, one that will decide in a fortnight whether to raise rates again, cannot afford to operate as a black box that most Australians misread in precisely the wrong direction.
The basic mechanism is not complicated. High inflation causes interest rates to rise. That is the whole sentence. Getting most of the country to understand it, really understand it rather than just repeat it, turns out to be harder work than anyone assumed.
Sources
The Bearing — Rate Rise Decision Making: Does the RBA Watch The Wrong Thing?
The Bearing — Growth Stalls as Inflation-Fighting Costs Compound
Frequently Asked Questions
Why do higher interest rates reduce inflation?
Higher rates reduce inflation by shrinking the amount of money people and businesses have available to spend. They work through multiple channels at once — mortgage repayments rise, saving becomes more attractive, borrowing costs on cars and business investment increase, asset prices fall, and a stronger dollar makes imports cheaper — all of which reduce demand and give inflation less fuel.
What happens if people don't believe the RBA can beat inflation?
If people expect prices to keep rising, they behave in ways that make that expectation come true. Workers bargain for higher wages, businesses raise prices pre-emptively, and consumers bring forward purchases — each individually rational decision reinforces the inflation the RBA is trying to stop. This is why public understanding of monetary policy is not just a communications nicety but a functional part of how rate rises work.
Why do so many Australians think rate rises make inflation worse?
Because rate rises do immediately make some things more expensive — mortgage repayments, rent for tenants whose landlords have variable-rate loans, business borrowing costs. The connection between that short-term pain and lower supermarket prices months later requires a chain of reasoning that is not intuitive and that financial institutions have historically done a poor job of explaining.
Did government spending cause Australia's inflation?
Fiscal policy and monetary policy interact, and government spending does affect demand — so the claim is not baseless. But Australia's inflation episode was shaped significantly by global factors: supply chain disruptions, energy price shocks, and post-pandemic demand surges that affected countries regardless of their domestic fiscal settings. Attributing the inflation entirely to domestic spending collapses that complexity into a single political cause.
What did RBA Governor Michele Bullock say about public understanding of interest rates?
Bullock acknowledged this week that the RBA needs to 'do a better job of getting out there and explaining to people in simple terms what is going on.' The admission came alongside survey data showing more than half of Australians believe rate rises make inflation worse rather than better — the opposite of what the RBA's policy is designed to achieve.