Rate rises won’t fix housing-driven inflation

The Reserve Bank’s decision to lift interest rates again reflects growing concern that inflation is not yet under control.

Headline CPI rose to 3.8% in the year to December, with trimmed mean inflation also edging higher, reinforcing the view that price pressures are proving more persistent than expected.

With inflation moving further away from the 2 to 3 per cent target band, the Bank has judged that additional restraint is required.

A key challenge, however, lies in the source of current inflation pressures. Housing costs are now the largest contributor to CPI inflation, rising by around 5.5% over the year, well above headline inflation. This category is made up primarily of rents, new dwelling purchase costs and household energy.

Rents continue to record strong annual growth, while new dwelling costs remain elevated due to high construction and labour costs. These pressures reflect a shortage of housing and a weak pipeline of new supply, and they are not problems that higher interest rates are well suited to solve.

Higher rates do little to address the underlying drivers of housing inflation. They do not reduce planning delays, ease regulatory costs or expand the construction workforce. Nor do they lower the substantial tax burden embedded in the cost of building a new home, including GST and state-based levies that add materially to final prices. 

Instead, higher rates lift financing costs, reduce development feasibility and further discourage new supply. In a market already characterised by chronic undersupply, this risks entrenching housing inflation rather than bringing it under control.

Sensitivity of the rental market

The rental market highlights this problem most clearly. The last sustained tightening cycle provides a useful reference point. 

After interest rates began rising in May 2022, the number of new loans to investors fell sharply, down 28% within 12 months. At the same time, rental inflation accelerated. By May 2024, rents nationally were 18.3% higher, with some cities, including Perth, recording increases close to 30%.

Much of this pressure was driven by strong population growth, including both international migration and elevated interstate migration toward labour markets with strong job creation. Higher interest rates reduced investor participation and new rental supply, but they did not reduce the demand created by employment growth. The result was fewer rental properties and significantly higher rents.

Government spending is also contributing to elevated housing costs, particularly through the scale of infrastructure investment. Large public infrastructure programs compete directly with residential construction for labour, materials and equipment, drawing capacity away from housing at a time when supply is already constrained. 

This crowding-out effect pushes up wages and input costs across the building sector, raising the cost of delivering new homes and slowing the pace of construction. In practice, this means fewer dwellings are built and those that are completed come at a higher cost, adding further pressure to housing-related inflation.

RBA in a tough spot

This leaves the RBA facing an increasingly difficult trade-off. Monetary policy can restrain parts of the economy that are still showing resilience, but one of the most significant sources of inflation sits largely outside its reach. Tightening policy may help ensure inflation expectations remain anchored, but it does not meaningfully ease the constraints pushing housing costs higher.

Where rate rises do have an effect is on house price growth following a period of particularly strong gains. While this is a positive development, it is not the objective of the RBA. The Bank’s mandate is inflation, not asset prices, and slower house price growth is simply a side effect of tighter policy rather than evidence that housing-driven inflation pressures are being resolved.

At the same time, government policy continues to add to housing demand. Generous first home buyer incentives, particularly schemes that allow purchases with deposits as low as 5%, increase the pool of buyers without addressing the underlying shortage of homes.

While these measures improve access to ownership for some households, they also intensify competition and place additional upward pressure on prices in the most supply-constrained segments of the market.

House prices, particularly at the more affordable end of the markets are going to keep rising, even as interest rates rise.