Reserve Bank of Australia (RBA) governor Philip Lowe made some extreme statements following yesterday’s interest rate hike.
Speaking at the RBA board dinner in Hobart, Lowe said that, while rising interest rates were hurting households, not doing anything could have far worse consequences.
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“We also discussed the consequences of not raising interest rates, and allowing high inflation to persist and become entrenched in expectations,” Lowe said.
“If this were to happen, the evil of inflation would be with us for longer and the eventual increase in interest rates needed to bring it down would be greater.
“This would increase the risk of a severe recession and a sharp rise in unemployment. It would be much better to avoid such a costly outcome and so we have acted strongly to avoid it.”
So, how exactly does making people pay more decrease the chances of a recession?
Here’s a breakdown of how it works.
Why does the RBA raise rates?
The main driver of the RBA hiking rates is inflation - or cost-of-living pressures.
Back in 2020, when the pandemic hit our shores, the central bank took emergency measures to reduce the interest rate to a record low 0.10 per cent.
It did this to make borrowing money significantly cheaper for the government, businesses and people.
The ultra-low cash rate was meant to help keep our economy running in times when our borders were shut.
When things opened back up, Australia recovered much quicker than anyone predicted - we’re spending machines as it turns out.
But, while we were ready to get things moving again, it was a different story around the world.
China, who we know produces most of the things we want to buy, is sticking to a COVID-zero policy and is constantly in an out of lockdown.
This has put continued pressure on supply chains. Coupled with higher energy prices - thanks to the war in Ukraine - and, boom, price pressures go through the roof.
The only weapon in the RBA’s arsenal is interest rates.
The RBA started raising the interest rate to make borrowing money more expensive.
The goal was to put pressure on borrowers so they stopped spending money on other things.
If we pull back on spending, the demand for things won’t be as high, so prices will come down.
Ultimately, the RBA is attempting to get inflation under control by making things more expensive.
It may seem counterintuitive, but it’s the only choice the central bank has.