What happens if interest rates don’t rise soon? The genie of inflation will be out of the bottle

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Australian economic policy is getting pretty clumsy. let me explain.

The economy is doing well, at least on paper. There’s just one problem: a major policy lever works like the economy is in intensive care.

The Reserve Bank’s interest rate target is 0.1 percent – the lowest on record.

It has been since the peak of the pandemic to stimulate the economy.

So should it be higher? Well, that’s where it gets awkward.

Why is the cash rate target so low?

The interest rate that adjustable rate borrowers pay on their loan is determined in part by the cash interest rate.

It’s what the Reserve Bank charges banks for short-term or overnight borrowing fees.

The RBA does not set the cash rate, but instead determines the “target” cash rate.

That is, it literally goes into the money market and signals traders where it wants the “cash price” and the market usually dutifully follows.

The system works so well that significant shifts in cash target rates have materially affected the level of broader short-term interest rates and what banks are willing to charge for their floating rates (benchmarked to short-term money market rates).

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

It is therefore crucial that the Reserve Bank can influence interest rates to increase borrowing again when credit or credit growth slows or slows.

Lending fell dramatically during the pandemic, causing the policy rate target to drop to 0.1 percent. But should it still be that low?

Reasons for a higher cash rate target

Reserve Bank Governor Philip Lowe recently said it was “plausible” that the bank could raise interest rates 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 – basically where it wants it to be – but headline inflation is uncomfortably high at 3.5 percent.

The unemployment rate is at a decade low, the gross domestic product is a whopping 3.4 percent.

In other words, there are signs that the economy is growing, creating jobs and inflation.

But is that what is going on in reality?

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

Two types of inflation

Inflation comes in two forms: demand pull and cost push.

Demand-pull inflation is created by higher-wage workers who have the confidence to spend big in stores.

Cost inflation occurs when business leaders pass higher production costs on to customers in the form of higher prices.

Cost-push inflation is now ingrained. But is demand-pull inflation a thing?

One could argue that this is because shoppers have been spending, but as the latest GDP numbers show, households have been using their savings to fund it.

The surge in consumer demand in the economy isn’t coming from confident workers spending their extra money from a pay raise.

inflation expectations

Do you feel like it’s getting a little embarrassing?

The RBA sees a need to raise interest rates because inflation is showing signs of getting hot, but at the same time it doesn’t see it as the type of inflation that’s likely to continue or intensify.

However, when companies fear their costs will continue to rise, they are now more likely to compete or bid with other companies for inventory and supply, further fueling cost inflation.

Of course, higher interest rates will not necessarily support this situation. It can even make it worse.

That’s because costs remain high for businesses, and they’re likely to generate less revenue as consumers pull back spending to meet higher borrowing costs.

The spirit of inflation

It’s enough to make you blush.

Inflation is rising. We all know that. It costs more to be on the road and it just seems to be getting worse.

Economists describe this feeling of uncontrolled inflation as the inflationary genie escaping the bottle.

That said, whether it’s cost-push or demand-push inflation, once it starts creeping higher it’s a challenge to get it back under control or back in the bottle.

A sign that says
The RBA must expect a burst of inflation.(ABC News: Daniel Irvine)

The primary policy tool for controlling inflation is the Reserve Bank’s interest rate target, but you can’t just raise the interest rate target and expect prices to fall. That will not do.

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

The RBA must expect a burst of inflation.

So far, the board believes a breakout is unlikely as aggregate wage increases that lead to demand inflation appear a long way off.

Where does that leave us?

let’s be honest There is no way to make this analysis clean and tidy. It’s cumbersome and messy.

Inflation is rising and there seems to be no sign of it falling again.

Research from ANZ Bank shows that inflation expectations are more likely to push inflation to 5 percent or more.

The silver bullet is a higher salary because that would make the higher cost of living more manageable, but that still seems like a pipe dream.

The RBA keeps its fire on interest rates because of the risk that tighter policy will derail a fragile economic recovery. But as economist Angela Jackson explains, you then run the risk of inflicting greater financial pain on households later.

“The main risk of the RBA holding the fire for too long is higher inflation, which ultimately requires faster rate hikes and greater risk of an economic slowdown,” she says.

“There is also a risk that asset prices, which have risen sharply in the two years since record-low interest rates were introduced, will continue to rise.

“This has increased wealth inequality and increased the risk of financial instability should those asset prices fall significantly once interest rates inevitably rise again.

“The slower the RBA can ultimately change interest rates, the better you can manage those risks.”

As with all incredibly embarrassing moments, it’s best to proceed very carefully.

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