The Reserve Bank hasn’t raised its official cash rate target for more than a decade, so many Australians have no adult experience of what a rate rise is like and why the RBA does it.
To be exact, the central bank’s last rate rise was 25 basis points (that’s financial lingo for 0.25 percentage points) in November 2010, which took the cash rate target to 4.75 per cent.
At every meeting since, the RBA board, which makes the decision, has either kept rates steady or cut them.
That’s left rates at a record low of 0.1 per cent, which is below what even the RBA thought possible in Australia several years ago.
But now inflation — the main measure of the cost of living, or how much your money is worth — has taken off.
This week, the Australian Bureau of Statistics released the official Consumer Price Index (CPI) that covered the first three months of this year.
The headline number was 5.1 per cent, which was about 0.5 percentage points higher than most economists were expecting.
But, while this grabbed the headlines, it’s not the number the RBA watches.
That’s because the headline CPI can get thrown around wildly by a lot of big, often one-off, price moves — think the $1.83 average petrol price Australians paid between January and March.
Instead, the central bank watches “core” or “underlying inflation”, which takes out the most extreme of these price moves.
These two measures — the trimmed mean and weighted median — were a lot lower at 3.7 and 3.2 per cent, respectively.
But they were also much higher than forecast — economists were again about 0.5 percentage points off the mark, and the Reserve Bank and Treasury boffins were even further adrift.
The most recent RBA forecasts expected core inflation to peak at 3.25 per cent around the middle of the year and then fall.
Instead, the actual numbers are well above that and expected to rise even further.
This is important because the Reserve Bank is tasked with, among other things like maintaining low unemployment, keeping inflation between 2-3 per cent.
Australia’s inflation rate is now very clearly well above that target, which is why most economists expect the Reserve Bank to act sooner rather than later by raising interest rates, probably next Tuesday afternoon (May 3).
Why does the RBA target inflation with interest rates?
But this raises the question that a lot of people have been asking since yesterday’s numbers came out: Why does the RBA raise rates and increase many people’s cost of living when our cost of living is already rising a lot?
EY Oceania’s chief economist Cherelle Murphy agrees it sounds counterintuitive.
“It does sound a little perverse, doesn’t it?” she told Patricia Karvelas on RN Breakfast.
Rising interest rates mean people with debt have bigger repayments and less free cash to splash, and it also makes people think twice before borrowing more money to spend on purchases. That’s how it reduces demand.
But isn’t strong demand a good thing?
It is, to a point. And what the latest inflation figures are saying is that we’ve probably already passed that point.
To put it simply, the problem is that, at any given time, the economy only has the capacity to produce a certain amount of goods and services.
If the demand from customers across the economy exceeds the capacity of businesses to provide those goods and services, then customers start competing against each other to get what they want.
They usually do this by paying higher prices.
If prices start rising sharply, workers will want to earn more so they can afford the increasing cost of living.
That means wage demands are likely to increase.
If unemployment was high, bosses could generally turn down these wage claims.
But with unemployment near half-century lows and one in five businesses telling the Australian Bureau of Statistics (ABS) they can’t find enough staff, there is now a better chance that more workers will be able to get their demands.
In turn, that means businesses will face even higher costs and, if demand is strong for their products, they will be able to pass those costs on to their customers through higher prices still.
And so the wage-price cycle goes, with inflation spiralling higher.
At extreme levels, this is very destabilising for an economy.
Imagine if you thought the money in your pay packet was going to be worth 5 per cent less next month than what it is now. What would you do?
You’d spend it all now, which makes inflation worse still.
You don’t have to look to the most extreme examples like Venezuela, Zimbabwe or Weimar Germany to see the damage inflation can do when it gets out of control. It’s happening right now in Turkey.
Turkey just recorded an annual inflation rate of 61 per cent, roughly equal to prices rising 5 per cent every month.
Inflation has never been that high in Australia, but it was much higher in the 1970s and 80s than it has been since, and those levels of price rises were seen to be hurting economic growth.
That’s why in the early 1990s the Reserve Bank joined other major central banks in setting a specific inflation target — interestingly, a trend started by the Reserve Bank of New Zealand.
The main idea is that if everyone knows the Reserve Bank will raise rates to cap demand as soon as inflation rises beyond a certain level, in Australia’s case 2-3 per cent, then it keeps expectations “anchored” — people won’t be making large wage demands and businesses won’t massively hike prices in the fear that costs will rise more than that.
Reasons for the RBA to raise rates now
There are a few other reasons most economists say the Reserve Bank should start raising interest rates soon (like next week) and a couple of arguments against it.
One reason to act immediately is the “stitch in time saves nine” argument, i.e. if you address a problem now it stops it getting worse and the solution being more painful, like a higher peak in interest rates if the RBA delays too long.
“So it’s kind of not about what’s happening now. It’s about what’s going to happen,” Cherelle Murphy explains.
“And if the Reserve Bank doesn’t get on top of inflation now and it starts to take off — and we’ve seen this, internationally, we’ve seen it in the US, we’ve seen it in the UK — we could be facing much more dire inflation.
Another factor is what other central banks are doing.
Some, like the Reserve Bank of New Zealand, started raising interest rates last year. The RBNZ cash rate target is already at 1.5 per cent, although its headline inflation rate is 6.9 per cent.
The US Federal Reserve hiked rates once in March by 25 basis points, but it is expected to raise them by 50 basis points in May and probably another 50 in June, taking its Fed funds rate to 1.25-1.5 per cent. Although, it too has much higher inflation at 8.5 per cent.
If Australia doesn’t start following soon, global investors will shift towards countries with higher interest rates, which will cut the value of the Australian dollar and push up the price of imports, which, you guessed it, will further add to inflation here.
One final argument in favour is the level of interest rates currently.
As ANZ’s head of Australian economics, David Plank, points out, this is the most stimulatory in Australian history.
What that graph shows is that the real value of money is shrinking by much more than the return on current interest rates.
If you consider variable mortgage rates, many of which are still about 2 per cent, at a 3.7 per cent rate of core inflation, the “real” value of the money you owe the bank — i.e. what you can buy with it — is falling faster than the interest being charged.
That’s why higher inflation is beneficial to borrowers as the “real” value of their debt is falling compared to the general increase in prices and wages.
It’s also why the current situation is terrible for savers, such as young people trying to build up a deposit to buy a home or older people living off bank deposits or other low-risk investments.
Their interest earnings are not keeping up with rising costs, so the value of their savings is shrinking.
Cherelle Murphy agrees with David Plank that the extremely low level of interest rates in the face of a strong economy shows they should be increased quickly.
“Why wait? Let’s get on with getting rates off the record low,” she says.
“We’ve got a 0.1 per cent cash rate. This is not a normal cycle.
“We’re sitting in a position where rates were lowered to that level because we had COVID, which was the biggest economic shock that we’ve really had since World War II.
Reasons for the RBA to wait until June
The two main arguments against raising rates are somewhat related, and have been most prominently articulated by the Reserve Bank governor himself.
The first is that most of the current inflation is not being driven as much by domestic demand as by temporary global supply-chain disruptions and shortages, due mainly to COVID-19 and conflict.
In that scenario, a bit less demand from Australia is not going to result in these global prices falling very much anyway.
And these prices will stop rising by themselves as the supply disruptions ease, so there is no need to suppress demand in the meantime.
Second, the RBA has said that it is waiting for more solid evidence of bigger wage rises before raising interest rates.
Currently (the most recent figures were for December), average annual wage increases of 2.3 per cent are running well behind inflation and have been much slower to increase. The next figures, for the March quarter, come out on May 18, after the RBA’s May 3 meeting.
Philip Lowe has previously said Australia’s wages “inertia” is partly due to public-sector wage caps and the modest size of minimum wage and award increases, but also due to enterprise agreements that lock in pay rises for several years.
Remember, if wages don’t ultimately follow prices higher, then inflation will be unsustainable. In the end, the rising cost of living would do most of the Reserve Bank’s work for it and limit demand in the economy.
However, economists have doubts either of those arguments still hold.
Westpac chief economist Bill Evans recently said measures of wages that include bonuses and promotions have already been growing much more strongly than the wage price index, which excludes these.
“I don’t think there’s any doubt that the pressures in the labour market are starting to show up in wages as well,” he said.
The latest inflation figures also showed that while goods inflation was much higher (6.6 per cent), services inflation was also around the top of the RBA target (3 per cent).
Most services are local, not imported, suggesting that it’s not only international supply chain disruptions and surging commodity prices sending inflation higher.
How high might interest rates go?
Overall, the economists at three of the four big banks are now tipping a May rate rise and financial markets are pricing in a virtual certainty of one.
How high rates will end up going is now the main point of contention.
CBA says the RBA might finish at a cash rate of 1.25 per cent by early next year, Westpac thinks it’ll reach 2 per cent sometime next year, NAB 2.5 per cent by 2024, and ANZ thinks it might top 3 per cent sometime over the next few years.
Cherelle Murphy says it all depends on what happens to inflation.
“If it keeps rising, then the Reserve Bank keeps lifting rates.”