Rising prices, an energy crisis, weak wage growth and now higher interest rates to boot. This has led many commentators to ask: why would the Reserve Bank of Australia seemingly make things worse by raising interest rates, particularly if high inflation is being driven by international and supply-side factors that are out of their control?
The argument, put most recently by Alan Kohler, goes something like this: raising interest rates lowers inflation by making our debts more expensive, dampening our demand for goods and services which means lower prices and thus lower inflation.
This all makes sense. But if the inflation we are experiencing is being driven by international factors, like the war in Ukraine or soaring global energy prices, why would raising interest rates be a good idea if Australia is too small to influence these international forces anyway?
Similarly, much of Australia's inflation is being driven by too little supply, not too much demand. Struggling supply chains, workforce shortages and higher business costs are contracting how much businesses can supply, causing prices and thus inflation to go up. Why would reducing demand through higher interest rates be a good idea if the problem is too little supply?
Finally, Kohler and others argue that a lot of the price increases we are seeing are for essential goods and services, not discretionary "luxury" items. If people have no choice than to buy these essential goods and services, then surely higher interest rates will have no effect, right?
Kohler has gone as far as to say that the Reserve Bank of Australia is deliberately seeking to push Australia into recession. He laments "the opposite of common sense" approach of raising interest rates, "especially when the inflation is caused by nothing that can be changed by raising interest rates".
Saying 'it's not our fault' doesn't really help anyone
These arguments are intuitive and compassionate. But they are also wrong. There are three main reasons for this.
First, suggesting that Australia's high inflation is driven solely by the supply side is an inaccurate reading of the data. Year-on-year, government consumption is up 8.3 per cent. Household consumption is up 4 per cent. Government capital expenditure is up 5.3 per cent. Private capital expenditure is up 2.7 per cent, with much more in the pipeline. Domestic demand on the whole is up 5.3 per cent. House prices are 25 per cent higher than they were prior to the pandemic, and the RBA's business liaison program points to an upcoming lift in wages growth.
In short, demand is coming in strong, and households still have plenty of ammunition left to fire. The household saving rate remains higher today than it was before the pandemic, and many households have built up substantial financial buffers. Households are a whopping four years ahead of their mortgage repayments. Mortgage defaults are falling, not rising. The RBA's 50-basis-point increase was bigger than expected. But when the incoming data is unexpectedly large, then the response will also be larger than expected.
To be sure, Australia's inflation challenge is definitely being made worse by supply-side challenges. But to suggest that demand isn't playing a role is not accurate.
Second, international forces are a double-edged sword. It's true that international factors are making inflation worse in Australia. The war in Ukraine is driving up energy prices and is sending lots of global demand our way for gas and agricultural products. Our terms of trade are at record highs. Trade and supply chain challenges are still being felt in many parts of the Australian economy, and prices are higher as a result.
International forces are making our inflation challenge worse. But it's wrong to say that higher interest rates in Australia don't impact those international forces.
MORE ADAM TRIGGS:
Monetary policy operates through its impact on domestic demand, as well as its impact on the exchange rate. When interest rates are higher in Australia, capital flows into the Australian economy to enjoy those higher interest rates. This pushes up the value of the Australian dollar and makes our exports relatively more expensive than those from the rest of the world.
Higher interest rates, therefore, reduce global demand for Australian goods. This eases prices for those goods and thus reduces inflation here at home. Suggesting that higher interest rates can't affect global forces is, again, not accurate. It's a good idea to put out a fire regardless of whether it started on your property or your neighbour's.
Third, even if inflation is purely the product of limited supply, history has shown us that supply-side inflation can quickly become demand-side inflation. It's a bit like a brawl in a stadium. Once an entire stadium of people are beating the crap out of each other, it doesn't really matter who started it. All that matters is that we need to stop it.
The same is true for inflation. Prices might initially go up because of supply-side challenges, but it doesn't take long for that inflation to feed into wages, government payments and every other payment that's indexed to inflation - kicking off the whole cycle once again. And as former RBA official Peter Tulip remarked recently, there is plenty of evidence that higher interest rates reduce inflation regardless of whether that inflation is due to demand or supply.
There is more we can do
And what about concerns that inflation is coming primarily from essential goods and services? It's true that analysis from the Australian Bureau of Statistics found that, from 2005-06 to 2020, inflation for essential goods and services was greater than inflation from discretionary goods and services. But this isn't the same as saying that all inflation came from essential goods and services.
In fact, the difference is not as substantial as some imply. While cumulative inflation for essential goods and services went up 43.8 per cent, cumulative inflation for discretionary goods and services also went up 31.8 per cent. There's plenty of demand for both.
This isn't to say that the inflation on essential goods and services isn't a problem. It's a big problem. The question is: what's the best solution to this problem? The answer is not to let inflation run rampant throughout the economy to protect one cohort of the community. Rather, the answer is to control inflation and better target government supports to those who need it; ideally offsetting any inflationary impact from these measures through reduced spending elsewhere in the economy.
Australia has a lot of options when it comes to addressing inflation. Monetary policy, macroprudential policies, tax policies, spending policies and, most importantly, supply-side reforms are all in our toolkit. There is an equilibrium interest rate which achieves full employment in Australia. We are probably still below it.
If the old adage that "high prices are the solution to high prices" was true, we would never have seen inflation run out of control. History has revealed the complete opposite.
- Adam Triggs is a director within Accenture Strategy, a non-resident fellow at the Brookings Institution, a visiting fellow at the ANU's Crawford School of Public Policy and a fellow at the e61 Institute. He writes fortnightly for ACM.
Adam Triggs
Adam Triggs is a director within Accenture Strategy, a visiting fellow at the Crawford School at the Australian National University, a non-resident fellow at the Brookings Institution, and a fellow at Macquarie University's E61 institute. He writes fortnightly for ACM.
Adam Triggs is a director within Accenture Strategy, a visiting fellow at the Crawford School at the Australian National University, a non-resident fellow at the Brookings Institution, and a fellow at Macquarie University's E61 institute. He writes fortnightly for ACM.
