If inflation has peaked, why does the RBA keep raising interest rates?

When will the RBA stop inflicting pain on the economy?

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Key points

  • The RBA just increased the interest rate by 0.25% to 3.35%
  • It’s expecting more increases in 2023 to tame inflation
  • The board wants to keep a lid on cost inflation and stop a wage growth spiral

The Reserve Bank of Australia (RBA) just increased the interest rate again despite inflation supposedly peaking. What's going on and how much more pain will be inflicted on mortgage holders and the S&P/ASX 200 Index (ASX: XJO)?

Yesterday, Australia's cash rate was increased by another 25 basis points, or 0.25%, to 3.35%. Remember that less than a year ago the interest rate was just 0.10%.

The main goal of central banks is to reduce inflation back down to its target range by taking some demand out of the economy. For the RBA, that target range is between 2% to 3% while keeping the economy on an even keel.

Inflation peaks in Australia?

As noted by the RBA, CPI inflation over the 12 months to 31 December 2022 was 7.8%, the highest since 1990.

In underlying terms, inflation was 6.9%. This was higher than expected and may be one of the key reasons why the RBA was concerned enough to announce that 2023 would see more rate rises.

The RBA believes that "global factors explain much of this high inflation, but strong domestic demand is adding to the inflationary pressures in a number of areas of the economy."

Employment remains very strong. The RBA called the labour market "very tight" with the unemployment rate "steady at around 3.5%", which is the lowest rate since 1974. Job vacancies and job ads are both at "very high levels", but have declined a little recently, with some businesses reporting a recent easing in labour shortages.

It noted that as economic growth slows, unemployment is expected to increase to 3.75% by the end of 2023.

Why are interest rates still going up?

The key factor seems to be that the RBA wants to do everything it can to avoid strong inflation. RBA boss Dr Lowe isn't focused on what's happening with ASX 200 shares. In the statement, the board said:

The board's priority is to return inflation to target. High inflation makes life difficult for people and damages the functioning of the economy. And if high inflation were to become entrenched in people's expectations, it would be very costly to reduce later.

While some cost inflation may have peaked, the RBA is keeping a close eye on wage growth, which is "continuing to pick up from the low rates of recent years and a further increase is expected due to the tight labour market." The RBA then said:

Given the importance of avoiding a prices-wages spiral, the board will continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead.

Despite the 0.25% increase, the RBA "expects that further increases in interest rates will be needed over the months ahead to ensure that inflation returns to target and that this period of high inflation is only temporary."

Plenty of economists thought the RBA would only do two further increases – yesterday's and one more, taking the rate to 3.6%. But, with the way the central bank's outlook was worded, could the rate reach 3.85%? Or even 4%?

It's possible the RBA may only go to 3.75%, but it seems interest rates are going to lift by more than most people were expecting.

The ASX 200 may be resilient as a whole in the face of these hikes. The US Federal Reserve seems to be slowing its rate increases, the ASX bank shares could benefit from higher rates, and the miners are benefitting from higher commodity prices. It's no mistake that the Commonwealth Bank of Australia (ASX: CBA) share price is close to $110 and its all-time high.

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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