Do you know what happens to inflation when the Reserve Bank of Australia (RBA) raises interest rates? 

Don’t google it, just go off your gut. Does inflation go up or down? 

If you said higher rates increase inflation, you’re not alone—more than half of Australians agree with you. Unfortunately, you’re also wrong.

Economic misunderstanding is rife in Australia. Recent research from Per Capita found that 45-50% of Australians think we live in a high-taxing, big government country (as opposed to either medium or low taxing), despite our tax per GDP being below the OECD average. Research from the RBA this year found a staggering number of misconceptions around different economic questions, and particularly around interest rates. When asked about interest rates’ impact on inflation, exchange rates and asset prices, responders to the research would have been better off flipping a coin (see the graph below).

At face value, this isn’t great. A lack of economic understanding leaves people vulnerable to being taken advantage of and makes it harder for governments to express clear messages  around economic policy. These misunderstandings can also have direct harms for economic outcomes, especially relating to  inflation. Economic misconceptions can change economic behaviour, and in some circumstances, make economic policy harder to implement.

One role of the RBA is their mandate to fight inflation, so they use interest rates as a tool to combat rising prices. When inflation is too high, they raise rates. This makes it more expensive to borrow money, and raises the price of mortgage repayments, among other things. It also makes it more appealing for people to save, as they’ll make more off cash sitting in a bank account if interest rates are higher. This reduces the demand in an economy and leads to downward pressure on inflation. As shown in the graph above, however, most Australians believe that higher rates worsen inflation. A factor in this could be the delay between when the RBA hikes rates and when inflation falls; for consumers observing the trends of the rate, they simply see rate increases correlating with inflation spikes.

This leads to a deeper problem. There’s a fundamental economic theory which contends that there is a relationship between our expectations of inflation and inflation itself. If you expect higher prices tomorrow, you demand more goods and services today at the lower price, and you demand higher wages to pay for the upcoming higher prices. Through wage negotiations, price-setting, consumption, investment and saving decisions, expectations help to influence price. The prophecy becomes partly self-fulfilling as these factors lead to higher inflation. If people believe that a rate hike will cause inflation, inflation expectations will rise, and the rate hike will be less effective at combatting inflation. Importantly, these expectations do not have to be true in the first place.

If consumers believe that the RBA is elevating rates to increase inflation rather than to combat it, that can erode trust in the central bank as an institution. Trust in an independent federal bank is essential for maintaining a confident, healthy economy. When Trump threatened to fire the chair of the US central bank last year, it “sent the markets into a tailspin”—and led to an almost immediate loss of 200 billion US dollars from the US market. This episode of ‘If You’re Listening’ by Matt Bevan discusses the harms of a central bank without public trust. The US case is indicative of how essential central bank trustworthiness is to economic prosperity.

Not only does RBA research show that a huge proportion of Australians hold fundamental economic misconceptions around key issues affecting day-to-day life, but it also demonstrates large disparities between groups based on age, gender, education and income (see the graph below). If economic misconceptions are concentrated among particular groups, then economic policy may be hardest to understand for the very people who are most exposed to its consequences.

Economics is complicated. It has not been solved, and there is rarely a policy that produces only benefits. More than that, it is often not intuitive. The trouble with trade-offs is that policies which are brilliant for combatting inflation could cause unemployment or hurt growth. Increasing the interest rates puts strain on households because it makes paying back loans more difficult. Rate hikes are known as a ‘blunt tool’ in the fight against inflation, because they do not only impact price, but they also have impacts on other economic outcomes (as shown in the first graph). Australians currently rate inflation as their biggest economic concern, well above housing, employment or climate change. Ironically, the third highest concern is interest rates; this shows how trade-offs operate to complicate economic decision making. This is the real challenge of economic literacy. There may be a correct answer to whether higher interest rates put downward pressure on inflation, but there isn’t always a simple answer as to whether raising them is the right thing to do.