How are inflation, interest rates and wages related?

The Reserve Bank aims to keep inflation within a range of 2-3% on average, over time. It is important for the decision-making of households and businesses that they can be sure that prices will continue to rise at approximately this rate.

How does the Reserve Bank control inflation?

It has added a few more tools to its “monetary policy” toolbox lately, but the main tool the Reserve Bank uses to influence the economy, and therefore inflationary pressures, is the cash rate.

The cash rate is the interest rate at which commercial banks lend overnight. The Reserve Bank used to intervene in the markets, buying and selling securities, to achieve whatever target cash rate it wanted. In practice, nowadays, all the Reserve Bank has to do is announce its desired target cash rate and market price movements towards it.

The cash rate is a key determinant (although not the only one) of bank funding costs. So when it increases, banks pass on this higher cost by increasing the interest rates they charge customers who borrow from them.

When the central bank wants to slow the economy to curb inflation, it raises its cash rate target, which in turn increases borrowing costs for households and businesses. This makes them less inclined to borrow, easing upward pressures on asset prices. For homeowners, this cooling of upward house prices makes them feel less wealthy and less inclined to spend.

Higher borrowing costs also directly impair the cash flow of mortgaged households, forcing them to spend less and making it harder for businesses to get buyers to accept price increases.

All of these factors – and more – contribute to alleviating the so-called “demand” in the economy. Less demand – all things being equal – means lower prices than otherwise.

But isn’t the recent spike in inflation simply the result of temporary supply disruptions? Don’t you need an explosion in wages to cause long-term sustainable inflation?

Maybe and yes.

War, COVID-19 and floods have all interrupted the supply of certain goods, driving up prices. But these interruptions and price increases have proven to be more durable than expected.

It is nonetheless true that wages, as tracked by the wage price index, have not yet increased much. According to the latest figures for the December quarter – which are admittedly quite old by now – wages rose only 2.3% last year, well below their historical average.

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But the widespread nature of inflation in the March quarter surprised the Reserve Bank. He also has information from his private liaison program with major employers that they are increasingly giving larger pay raises to certain employees.

Speaking immediately after Tuesday’s interest rate decision, Reserve Bank Governor Phil Lowe said the past two months had seen “a very marked change” in what companies were saying to the bank. future salary increases. “Most companies used to say ‘well, 2 maybe 2.5%’ and now around 40% of companies are answering that question saying they’re going to pay raises in excess of 3 % and a significant number of companies say they “will pay wage increases greater than 3 percent.

Perhaps something that started as a supply shock could end up fueling demand as workers demand and get bigger wage increases to compensate them for the rising cost of living.

How much should wages increase each year?

In normal times, workers can expect pay rises that keep pace with the rising cost of living and reward them for any increased productivity they have brought to the table.

Historically, it has been 2.5% for inflation, plus 1 or 2% for productivity growth, so 3.5 to 4.5%. However, this can vary enormously over time.

Wages are also determined by the bargaining power of capital versus labor. Unionization rates have declined over the past decades, while globalization has also brought increased competition from foreign labour. Advances in technology have replaced many workers with robots or computers. This led to historically slow wage growth that led to the pandemic.

So, is the Reserve Bank right to raise interest rates?

Time will tell if current inflationary pressures are as entrenched as many fear and how successful workers will, in fact, be in demanding bigger wage increases.

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Critics say the bank has waited too long to begin its process of returning the cash rate to a “neutral” level – a level where interest rates do not stimulate the economy and do not exert a knock-on effect. contraction.

On the other side, some still view inflationary pressures as largely transitory and fear that wages will not recover as expected and that the Reserve Bank, if it acts too quickly, could accidentally tip the economy into recession. .

Leslie M. Gill