Interest rates are a blunt tool for tackling inflation, and can hurt the people least able to absorb higher costs.
Abraham Maslow, an eminent psychologist, once said, “If you only have a hammer, you tend to see every problem as a nail.” This seems to be the response to inflation by the Reserve Bank of Australia (RBA), acting as if its only tool is increasing interest rates, a crude and unjust response to a complicated problem.
Inflation arises when demand for goods and services is greater than supply. More precisely, if demand is greater than national economic capacity (raw materials, industries, labour force, skills, education) and available imports, then inflation is likely.
Raising interest rates is intended to reduce demand for goods and services across the board. It is crude because inflation can have many causes, including supply shocks, high aggregate demand, demand for a particular product such as oil, financial speculation, exchange-rate movements, labour shortages, geopolitical disruptions, monopoly pricing and other forms of profiteering. It will have little if any benefit in controlling inflation resulting from several of these causes.
Raising interest rates is unjust because it penalises individuals and businesses who have borrowed money, but benefits those who have savings and investments. It benefits the wealthy while harming those with low and medium incomes.
Recent reform of the Reserve Bank gives it two specific objectives within the overarching goal to “promote the economic prosperity and welfare of the people of Australia, both now and into the future”. These objectives are (1) stability of the currency and (2) full employment.
Unfortunately, the RBA’s preferred strategy for its first objective undermines its second objective. Raising interest rates reduces spending by mortgage holders and by everyone who buys anything. It is making home ownership even more unaffordable, driving increases in rents for homes and increasing unemployment.
When demand falls across the board, fewer shop assistants, tradespeople, hospitality staff, importers and industrial workers are needed. Higher interest rates can also increase unemployment by reducing investment and increasing business failures.
Driving unemployment is not an accidental side effect of the RBA’s inflation strategy, but a deliberate result of the neoliberal economic notion that a trade-off exists between inflation and unemployment. This notion is dressed up as the quasi-scientific hypothesis that a unique non-accelerating inflation rate of unemployment (NAIRU) exists. When unemployment is above an arbitrarily chosen NAIRU value, then neoliberal dogma claims that inflation should decelerate and vice versa. This hypothetical relationship is called the Phillips curve.
A result of adopting this notion was that many mainstream economists and the RBA abandoned the former goal of full employment or, more precisely, redefined ‘full employment’ to be the NAIRU which, depending upon method and the year, has been chosen to be anything from 4–8 per cent.
As a scientist, I’m appalled by this poorly based notion to ‘justify’ increasing interest rates, because (see here and here):
- Empirically, the relationship between inflation and unemployment does not generally follow a Phillips curve.
- The NAIRU is unobservable and the various methods of choosing its value are arbitrary, inconsistent with one another, and change with time.
- The theoretical ‘justification’ depends on dubious assumptions of neoclassical economics; for example, the economy is assumed, contrary to observation, to be a static system with equilibrium between supply and demand.
Raising interest rates does little to reduce inflation when supply shocks are caused by, for example, wars, pandemics, shipping disruptions and monopoly pricing. In some circumstances, it may actually drive an increase in inflation.
Governments could address profiteering by the big supermarket chains by controls on price increases. They could put price controls on rents. They could tax excess profits of the fossil gas industry. They could increase GST on inessential goods and services. They could increase competition by stopping monopolies and mergers between large firms, and breaking up dominant firms.
The focus should be on ensuring the basic necessities of life – food, energy (not necessarily fossil fuels), medical care, education, housing – remain affordable.
The recent reductions in the excise duty on petrol and diesel, resulting from the US-Israel war on Iran, gave incentives for increasing fossil fuel use and hence greenhouse gas emissions. Instead, in the short term, the government could target any future subsidies on petrol and diesel prices to remote and regional areas and to those outer suburbs of cities where there’s still inadequate public transport.
In the medium and long term, the government could increase the reach and frequency of urban public transport and intercity rail; improve facilities for cycling and walking in cities; and provide more charge stations for electric vehicles.
Electricity generation by peak-load gas-fired power stations, together with the frequent breakdowns of coal-fired power stations, is the principal driver of high electricity prices. Until cheaper utility-scale batteries replace most peakers, the government could temporarily compensate low-income households directly.
In designing its strategy for managing inflation in the medium to long term, governments should pay more attention to expanding national economic capacity. Key areas are renewable energy, energy storage, electric vehicle charging, public transport including high-speed intercity rail, workforce education and training, childcare, housing construction, and key industries.
While the RBA claims that the inflationary pressures are being driven by chronic excess demand, labour economist Bill Mitchell presents data to show that 27 per cent of the available productive capacity of the economy is not being utilised. This substantial excess capacity could be utilised for increased government spending on green energy and transport, and universal public services generally.
Renewable energy, energy storage and electric vehicles reduce inflation risk from oil imports. Public transport can, in effect, expand the geographical labour market without contributing to inflation. A workforce that is well educated and trained to be flexible in work activities is vital for the necessary transition to greener industries providing local employment.
To control inflation, we need targeted government policy, not unscientific hocus-pocus by the RBA.
Dr Mark Diesendorf was originally a physicist who expanded into interdisciplinary research on energy and sustainability. Previously he was Professor of Environmental Science and Founding Director of the Institute for Sustainable Futures, University of Technology Sydney. Currently he is Honorary Associate Professor in the Environment & Society Group in the School of Humanities & Languages, UNSW Sydney. Web: https://research.unsw.edu.au/people/associate-professor-mark-diesendorf. Mark is the lead author of ‘The Path to a Sustainable Civilisation: Technological, socioeconomic and political change’ (Palgrave Macmillan, 2023).