Reserve Bank of Australia (RBA) governor, Phil Lowe, has just given his opening Statement to the House of Representatives Standing Committee on Economics, in which he outlined the case for further interest rate hikes.
Below are key extracts, with my emphasis added in bold:
Global factors explain much of this increase in inflation. Russia’s invasion of Ukraine resulted in major disruptions to energy markets, increasing retail energy prices around the world. And COVID-related interruptions to global production are still rippling through global supply chains, pushing prices up. The demand for goods in global markets has also been very strong over the past few years as people switched their spending from services to goods. The result of impaired supply and strong demand has been higher prices around the world.
Important as these global factors have been, they are not the full story for why inflation is high in Australia. Demand here has been very strong relative to the ability of our economy to meet that demand. This is clearly evident in the labour market, where the number of job vacancies is at a record high and firms are finding it hard to hire workers. There are also capacity constraints in many sectors, including the building of infrastructure and the housing industry.
This strong demand is, in part, a result of the policy approach during the pandemic. During 2020 and 2021, both fiscal and monetary policy provided very considerable economic support to households and businesses. At the RBA, we did this to provide a financial bridge to the day when the virus was contained and to provide some insurance against the possibility of very bad economic outcomes…
Vaccines were developed in record time and our economy – with the support of monetary and fiscal policies – proved to be very resilient. We avoided the dire outcomes that many thought likely. And today, many people are returning back towards their pre-pandemic way of life and are spending again, including on travel and services. We saw further evidence of this last week in the National Accounts, with the Australian economy growing by 0.9 per cent in the June quarter, and by 3.6 per cent over the year. These are good outcomes, and they are better than those being recorded in most other countries…
Now that inflation is as high as it is, we need to make sure that inflation returns to target in reasonable time. A powerful lesson from history is that low and stable inflation is a prerequisite for a strong economy and a sustained period of full employment. High inflation damages our economy, worsens inequality and devalues people’s savings. High inflation also makes it very difficult to sustain, or increase, real wages. It is a scourge. It is for these reasons that the RBA is committed to returning inflation to the 2 to 3 per cent target range over time…
The RBA will do what is necessary to make sure that higher inflation does not become entrenched and we are committed to returning inflation to the 2 to 3 per cent target range. We are seeking to do this in a way that keeps the economy on an even keel. It is possible to achieve this, but the path here is a narrow one and it is clouded in uncertainty.
One important source of uncertainty is the global economy, where the outlook has deteriorated…
Another factor that will determine how successfully we navigate that narrow path is how inflation expectations and the general inflation psychology evolve in Australia. To date, medium-term inflation expectations have remained well anchored, which is good news. But the general inflation psychology appears to be shifting; it is easier for firms to put their prices up and the public is more accepting of this…
Wages growth has also picked from the very low rates of recent years and a further increase is expected due to the very tight labour market. Stronger wages growth is something that the RBA had been seeking for a number of years and some pick-up is welcome. It is also important to note that, to date, the stronger growth in wages has not been a major factor driving inflation higher and, at the aggregate level, growth in labour costs remains consistent with inflation returning to target…
A third issue we are watching carefully is household spending. Consumer sentiment has fallen, household disposable income is under pressure from higher interest rates and higher inflation, and housing prices are declining after large gains. On the other hand, many households are benefiting from the strong labour market, including by finding jobs and getting more hours of work. Some households are also continuing to save at a higher rate than before the pandemic. Quite a few have also built up large financial buffers, although many other households have only very limited buffers. In the face of these competing factors, the recent data suggest that spending has remained resilient so far. There is, though, considerable uncertainty as to how these factors will balance out over the months ahead and we are watching the situation carefully.
In terms of the outlook for interest rates, the Reserve Bank Board expects that further increases will be required to bring inflation back to target. We are not on a pre-set path, though, especially given the uncertainties I have just spoken about. The increase in interest rates has been rapid and global and we know monetary policy operates with a lag. At some point, it will be appropriate to slow the rate of increase in interest rates and the case for doing that becomes stronger as the level of interest rates increases. As I have said previously, the size and timing of future interest rate increases will be guided by the incoming data and the Board’s assessment of the outlook for inflation and the labour market.
Phil Lowe’s statement that the “increase in interest rates has been rapid” and that “monetary policy operates with a lag”, but “the size and timing of future interest rate increases will be guided by the incoming [backward-looking] data” does not fill me with confidence.
Last week, the CBA’s head of Australian economics, Gareth Aird, released research showing that it takes an average of two-to-three months for an increase in the OCR to be felt by mortgage holders.
Therefore, most of the RBA’s rapid monetary tightening has yet to be felt by Australians with mortgages, meaning “there’s a degree to which the RBA Board is flying blind. It has simply been too early for the spending data to pick up the impact of the already delivered rate hikes”.
Separately, Aird likened the RBA’s aggressive tightening to “having five shots of vodka in an hour and saying, everything is OK. But you know that it will soon have a big effect”.
I firmly believe the RBA has hiked rates too far, too quickly, and should pause to see what the effect is. Otherwise, it risks driving household consumption off a cliff and plunging Australia into recession.
I also expect the RBA to cut rates mid next year. By then, the delayed impact of rate hikes will have arrived with house prices having fallen sharply, the economy stalling, and inflation declining.
After seeing the RBA go too hard on tightening, expect to see it reverse course and slash rates next year to stave off recession.
