What happens if interest rates don’t go up soon? The “genius” of inflation will come out of the bottle

Australian economic policy is getting rather clumsy. Let me explain.

The economy is doing well, at least on paper. There is only one problem: a key policy lever is acting as if the economy is in intensive care.

The Reserve Bank’s cash rate target stands at 0.1%, the lowest on record.

It’s been at this rate since the height of the pandemic to help energize the economy.

So should it be higher? Well, this is where it gets awkward.

Why is the cash rate target so low?

The interest rate that variable rate borrowers pay for their loan is set, in part, by the spot rate.

This is what the Reserve Bank asks banks to borrow in the short term or overnight.

The RBA does not set the cash rate, rather it determines the “target” cash rate.

This means that he literally walks into the money market and signals to traders where he wants the “spot rate” to be and the market, normally, dutifully follows.

The system works so well that significant changes in the cash rate target have significantly influenced the level of short-term interest rates more generally and what banks have felt comfortable charging for their variable interest rates (referenced to short-term money market rates).

Credit growth by sector. (Source: ABS, APRA, RBA)

It is therefore crucial that when loan or credit growth slows or falls, the Reserve Bank can influence the cash rate to increase borrowing again.

Lending fell dramatically during the height of the pandemic, which is why the cash rate target fell to 0.1%. But should it still be so low?

Reasons for a higher cash rate target

Reserve Bank Governor Philip Lowe recently said it was “plausible” the bank could raise the cash rate target later this year.

This slight change in message is due to the fact that the economic landscape has changed.

Underlying inflation is within the RBA’s target bank – essentially where it wants it to be – but headline inflation is uncomfortably high at 3.5%.

The unemployment rate is at its lowest in several decades, while the gross domestic product is at 3.4%.

In other words, evidence is emerging that the economy is growing and generating jobs and inflation.

But is this really what happens in reality?

Space to play or pause, M to mute, left and right arrows to search, up and down arrows for volume.
Play the video.  Duration: 3 minutes 1 second

The Reserve Bank’s balancing act on interest rates(Gareth Hutchins)

Two types of inflation

Inflation comes in two forms: attracting demand and raising costs.

Demand-pull inflation is generated by higher-paid workers having the confidence to spend a lot in stores.

Cost-push inflation arises when business owners pass on higher production costs to customers in the form of higher prices.

Cost inflation is now deeply entrenched. But is demand-driven inflation a thing?

You could say it’s because shoppers spent, but as the latest gross domestic product figures show, households dipped into their savings to fund it.

The increase in consumer demand in the economy does not stem from confident workers spending their extra money through a pay rise.

Inflation expectations

Do you feel this is starting to get a bit awkward?

The RBA feels the need to raise interest rates because inflation is showing signs of warming, but at the same time, it is not seen as the type of inflation that is likely to persist or intensify.

That said, if businesses fear their costs will rise further, they are more likely to compete or bid with other businesses for inventory and supplies now, further adding to cost inflation.

Of course, higher interest rates will not necessarily help this situation. It can actually make things worse.

Indeed, costs to businesses will remain high and they are likely to receive less revenue as consumers reduce spending to meet higher borrowing costs.

The “genius” of inflation

It’s enough to make you blush.

Inflation is on the rise. We all know that. It costs more to get out and it seems to get worse.

Economists describe this sense of rising, unchecked inflation as the “genie” of inflation escaping from the bottle.

In other words, whether it’s cost-driven or demand-driven inflation, once it starts to climb, it’s hard to get it under control or put it back in the bottle.

A sign saying "Reserve Bank of Australia" on the exterior wall of the RBA headquarters in Sydney
The RBA must anticipate a surge in inflation.(ABC News: Daniel Irvine)

The primary policy tool for controlling inflation is the Reserve Bank’s cash rate target, but you can’t just raise the cash rate target and expect prices to fall. It does not work like that.

This part of the “interest rate policy cycle” is more art than science.

The RBA must anticipate a surge in inflation.

So far, the board has felt a breakout is unlikely as economy-wide wage increases, which lead to demand-driven inflation, still seem a long way off.

Where does this lead us?

Let’s be honest. There is no way to make this analysis neat and tidy. It’s clunky and messy.

Inflation is on the rise and nothing seems to indicate that it is coming down.

ANZ Bank research shows that inflation expectations will push inflation up to 5% or more.

The quick fix is ​​a higher salary, as that would make the higher cost of living more manageable, but that still seems like a pipe dream.

The RBA is keeping interest rates on fire because there is a danger that tighter policy will derail a fragile economic recovery. But as economist Angela Jackson explains, you run the risk of causing more financial hardship for households.

“The main risk of the RBA holding fire for too long is higher inflation, which will ultimately require a faster rise in interest rates and greater risk of an economic downturn,” she said.

“There is also a risk of sustaining further increases in asset prices, which have increased massively in the two years since the introduction of historically low interest rates.

“This has increased wealth inequality and increases the risk of financial instability if the prices of these assets were to fall significantly once interest rates inevitably begin to rise again.

“The slower the RBA can ultimately move on interest rates, the better it manages those risks.”

As with all incredibly awkward moments, it’s best to be very careful.

Leslie M. Gill