Four rate rises have already squeezed household incomes and slowed demand. Unless underlying inflation jumps unexpectedly this week, another increase risks inflicting unnecessary economic suffering.
Since the beginning of this year the Reserve Bank (RBA) has increased interest rates four times, with its cash rate rising from 3.6 per cent to 4.6 per cent. These increases in official interest rates have been fully passed on to homeowners with a mortgage so that someone with a typical mortgage of $650,000 is now paying an extra $400–420 per month.
Compared to a median wage after tax of approximately $1,425 per week this increase in interest rates has resulted in a very substantial reduction of around 7½ per cent so far this year in the typical mortgagee household’s disposable income. This is a very substantial hit to living standards and no wonder people’s biggest concern is the cost of living.
Until the last week or so, most private sector economists and financial markets widely expected that there would be no further interest rate increases, at least for the time being.
However, a question-and-answer session with the deputy governor of the RBA, Andrew Hauser, last week has shifted opinion on whether the RBA will lift its cash rate again on Melbourne Cup Day next week. Before Hauser’s intervention, financial markets were pricing in the chance of a hold in interest rates at 81.5 per cent, but now they are pricing in the chances of an increase at 50–50 or even a bit stronger.
Hauser points to three reasons for an increase in the RBA inflation forecasts. First, and most importantly, is the recent rapid upsurge in oil prices. In August, the RBA expected oil to be around US$80 per barrel, but oil prices have surged to close to US$110 per barrel, and the risk is that they will stay higher for longer than previously forecast.
In addition, Hauser also points to an increase in AI prices and capacity pressures on the prices for some services. But it is questionable how important these other two sources of price increases are.
Apart from AI, business investment is generally weak, and Hauser himself admits that the labour market is already easing, with rising unemployment, and that “consumption growth is quite tepid”.
Thus, it is likely that if the RBA inflation forecasts do need to be revised upwards, the main reason will be the increase in oil prices.
However, the RBA bases its interest rate determination on what it calls the trimmed mean, which strips out one-off price spikes, like an oil price spike, and gives a cleaner read on persistent price pressure. There is therefore a good chance that this increase in oil prices will not damage the RBA’s inflation forecast based on the trimmed mean too much.
But even if the increase in oil prices has started to push other prices up further, there is a legitimate question about how helpful interest rate increases are in dealing with a supply shortage rather than with excess demand. After all, an interest rate will not bring down the price of oil, and that in itself should not be a justification for another interest rate increase, unless that oil price increase is having a significant impact on other prices.
In addition, we also need to recognise that the full impact of monetary tightening only operates with a lag. It is therefore likely that the four recent increases in interest rates will continue to slow inflation further in the months ahead.
In short, monetary policy is working to dampen demand, and that will continue, so why do we need yet another interest rate increase?
The main reason cited by the RBA is their worry that after several years of inflation higher than the bank’s target range of 2–3 per cent, expectations about the future rate of inflation may be shifting up and that will result in a self-fulfilling prophecy.
As Hauser says, “there is an increasing share of businesses who are thinking that maybe three to three and a half per cent is the new normal”, but the bank “can’t allow expectations to shift away from the target”. Furthermore, the longer it takes to return inflation to its target range, the harder and more damaging it will be to achieve that goal.
But the critical issue then is how confident can we be that inflationary expectations have shifted up and are affecting future pricing behaviour?
In the past, wage increases played a major role in driving inflation, with wages being the major cost of production. Many economists remember the wage-price spirals that led to inflation and wage increases of around 10 per cent or more in the 1970s and 1980s. It is understandable that the authorities never want to repeat that experience again.
But the arrangements underpinning wage determination are completely different today. Centralised wage determination through a national wage case no longer exists. Enterprise bargaining or even individual wage negotiation determines most wages, and in addition trade unions are very much weaker.
So the chances of a wage breakout leading to higher inflation are almost non-existent. Indeed, the reality is that for the last few years, wages have not even kept pace with the prices of goods and services, and wage increases cannot possibly be blamed for the unacceptable rate of inflation.
As Hauser recognises, the more “you do to tackle higher inflation, … that means weaker activity, weaker labour market”. But if we want to avoid an unnecessary recession, then what should influence the RBA is the update of the most recent rate of inflation which will become available from the ABS this week.
If that increase in the trimmed mean is significantly higher than previously forecast by the RBA, it would be understandable if the RBA increased its cash rate again. On the other hand, if the latest inflation data for the trimmed mean are largely consistent with past forecasts, then the obvious course would be to pause and not increase interest rates this month and at least wait until the next RBA meeting in December.
Michael Keating is a former Secretary of the Departments of Prime Minister and Cabinet, Finance and Employment, and Industrial Relations. He is presently a visiting fellow at the Australian National University.