The interest rate hike that will slow the nation

As was widely anticipated, the Reserve Bank of Australia’s (RBA) Monetary Policy Board increased the cash rate by 25 basis points on Melbourne Cup Day to 4.85%, the highest level in 18 years.

While geopolitical tensions have pushed global energy prices higher, adding to fuel and other commodity costs, domestic capacity pressures are the core driver of Australia’s inflation challenge. In fact, in the rate announcement, the RBA revealed that capacity pressures have been greater than previously thought.

Despite four rate hikes earlier in the year, inflation remains firmly above the RBA’s target band. Last week’s inflation data reported headline inflation coming in at 4.3% over the year to the month of September, with the trimmed mean (the RBA’s preferred measure of underlying inflation) sitting at 3.7% over the 12 months to the September quarter. The resulting assessment is that even with economic growth moderating, the economy continues to run hotter than is sustainable.

Altering the cash rate is often viewed as a blunt instrument, leaving parts of aggregate demand (such as public spending) relatively unaffected while private demand (such as households) bears the brunt. Even so, for aggregate demand to decrease by any substantial amount, private demand must taper.

Indeed, at least at an aggregate level households continue to outperform spending expectations. The latest Monthly Household Spending Indicator data showed a 6.9% increase in discretionary spending over the year to September, measured in nominal terms. This reflects the average spending growth across households. Indeed, the RBA’s October 2026 Financial Stability Review found that, as of July, the median borrower had sufficient savings buffers to cover approximately one year of scheduled mortgage payments – a stronger position than was the case prior to the pandemic.

However, aggregate resilience masks considerable differences between households. Higher mortgage repayments are placing significant pressure on low income and highly leveraged borrowers. According to Roy Morgan data, 31.8% of mortgage holders (some 1.75 million households) were at risk of mortgage stress in September, up 7.9 percentage points this year. Following the latest increase in the cash rate, this is expected to increase to approximately 1.82 million.

As the increase in mortgage rates is the most obvious effect of monetary policy for households to observe, it often gains considerable public attention. However, it may be surprising to many that the cash flow channel (which reflects the transmission of cash rate changes to mortgage rates) is not the most important channel in terms of moderating inflation.

Modelling by the RBA indicates that up to two thirds of the effect of interest rates on the economy comes through the exchange rate channel. All else equal, an increase in interest rates increases the return on Australian assets, pushing up the exchange rate. This makes imported goods cheaper, aiding in moderating inflation, as well as making exports less competitive (leading to lower net exports and slower growth). Since the start of the year the Australian dollar has appreciated from 67 to 70 US cents.

Tuesday’s decision reflects the Board’s concern that allowing inflation to remain elevated for longer risks embedding higher inflation expectations. The immediate outlook remains finely balanced. As the effects of this year’s rate increases continue to work through the economy, the RBA will look to upcoming inflation data for evidence that domestic price pressures are easing. However, with inflation risks still skewed to the upside, further tightening remains possible if inflation proves more persistent than expected.

This newsletter was distributed on 6 November 2026. For any questions or comments on this week’s newsletter, please contact our authors.