Commodity prices are rising and inflation is rising. Should interest rates also rise?

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There’s more inflation to come.

The Kremlin’s invasion of Ukraine and sanctions against the Russian Federation have sent oil and energy prices skyrocketing.

The catastrophic floods on Australia’s east coast have caused severe food shortages.

In response, supermarkets will raise prices.

But will these rising prices force the Reserve Bank to raise interest rates ahead of schedule to keep inflation under control?

There are two schools of thought.

Global events dominate

Western governments’ response to the Russian invasion of Ukraine is rapidly evolving.

At the beginning of last week, the European Union presented plans to cut its Russian gas imports by two-thirds by the end of the year.

A few days later, it revealed its Fourth package of measures to further isolate Russia and deplete the resources it is using to fund its war.

Russia warned of “catastrophic consequences” for the world market if the West stopped its oil and energy exports.

Then the United States said it would ban all imports of Russian oil, gas and power, and Australia and the United Kingdom announced their own oil bans.

Analysts say it’s hard to keep up.

However, Reserve Bank of Australia Governor Philip Lowe says rising commodity prices will trigger a new wave of inflation around the world.

“This new supply shock will extend the period that inflation stays above central banks’ targets,” he warned last week.

“This poses a risk that the low-inflation psychology that has characterized many advanced economies over the past two decades begins to shift.”

What does all this mean for monetary policy?

The monetary policy challenges are increasing

The consequences of the Russia-Ukraine conflict will complicate the monetary policy challenges for the central banks.

Why?

Because sharp increases in energy and food prices will increase inflationary pressure, but will also dampen economic growth.

dr Lowe fears that if Australians believe inflation will continue to rise, they will start to act accordingly ensures it happens.

To prevent this, some economists say central banks should raise interest rates sooner rather than later to keep people’s inflation expectations “anchored”.

However, other economists warn that raising interest rates prematurely would dampen economic activity at exactly the wrong time.

Independent economist Saul Eslake says it is this contradiction that makes decisions about when and by how much to tighten monetary policy much more difficult going forward.

Rising commodity prices, supply shocks and inflation

Rabobank analysts say we’re in for the biggest supply shock since the aftermath of the 1973 Yom Kippur War.

They say that the two major supply shocks of the 1970s – both oil-related – led to “stagflation” in that decade and contributed to the collapse of the financial order after World War II.

Rabobank analysts say these charts do not fully reflect recent price developments. They also say commodity prices could continue to rise if the war in Ukraine escalates.(Source: Rabobank)

However, analysts at HSBC have also pointed out that the world’s economies are now far less dependent on oil than they once were.

They say the number of barrels of crude oil needed to produce $1,000 of GDP peaked in the 1970s during the first oil price shock and has been declining for the United States, Japan and the world since then.

They say there are two main reasons for this.

“First, we’ve become more efficient at using the gooey stuff,” they told customers last week.

“Second, economies have shifted from manufacturing to services that use less energy (oil, at least).

“This generally means that rising oil prices should be less of a drag on economic growth today than they have been in the past.”

They say the same is true for emerging Asia, but that oil intensity in India and ASEAN is still significantly higher than elsewhere.

oil intensity
The number of barrels needed to produce $1,000 of GDP has tended to decline over time(Source: HSBC Global Research)

Economists say there are reasons to believe inflation should be easier to control at this point compared to decades past.

They say that the major central banks are now independent where they were not in the 1970s and that they have done a good job of managing inflation expectations over the past few decades.

This includes the Reserve Bank of Australia.

Although Australians are beginning to believe inflation will be higher in the short term, they are not yet in doubt that the RBA will struggle to keep inflation under control over the longer term.

This is an important difference between today’s situation and the 1970s.

If that were to change, the RBA might have to raise rates more.

But for now, the RBA might even state that higher petrol prices and higher food prices, which will contribute to higher inflation in Australia in the coming months, could perversely mean interest rates don’t need to rise significantly to keep inflation under control.

Why? Because higher fuel and food prices could dampen demand other Goods, avoiding the need for the RBA to raise interest rates significantly.

In any case, RBA Governor Philip Lowe says he’s willing to be patient before taking any action on interest rates.

He says headline inflation in Australia is currently much lower than other major economies.

headline inflation

He says consumer inflation in the United States is at 7.5 percent, the fastest rate in 40 years.

Inflation rates in the UK, Germany, Canada and New Zealand are also at their highest levels in decades.

But in Australia, headline inflation is currently 3.5 percent, less than half the rate in the United States. The bottom line is only 2.6 percent.

However, so much depends on events in Europe that it is impossible to predict how events will unfold from here.

“It is plausible that the cash rate will be increased later this year,” said Dr. Lowe last week.

“I recognize that there is a risk of waiting too long, especially in a world of overlapping supply shocks and high headline inflation.

“But there is also a risk of moving too soon.

“Recent developments in Europe have increased the complexity here. The Reserve Bank will respond as needed and do whatever is necessary to maintain low and stable inflation in Australia,” he said.

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