The Rhetoric of Responsibility
How the RBA is surfing the inflation wave.
Inflation has been hard to miss in recent months. The Consumer Price Index is up 5.1%, the Reserve Bank just raised the cash rate for the second time in a decade, and the federal election foregrounded the ‘cost-of-living crisis’.
Commentary has latched onto the story of the 1970s when oil supply shocks were the catalyst for the phenomenon of stagflation — in which growth is stagnant and both unemployment and inflation run rampant. While it would be inappropriate to summarily dismiss the possibility of stagflation, it is equally inappropriate to ignore the differences between the 1970s and today and claim that the challenges we face are nothing more than history repeating itself.
What is happening?
Although there is a great deal of uncertainty surrounding where inflation is going, there is some agreement about how it started. To a large extent, all of the factors driving inflationary pressure originated in the effects of and responses to the pandemic.
In response to lockdowns, governments around the world pumped cash into the economy — just look at JobKeeper and JobSeeker in Australia for an easy example. This fact alone makes it seem like this is the classic cautionary tale that inflation hawks warn about: the government spent too much and now look what’s happening! But that narrative is far from the whole story, and there are compounding factors to consider.
First, while many consumers were being handed fistfuls of cash to stimulate the economy, there wasn’t anything left to spend it on. With restaurants shut, travel cancelled, and not much to do other than stay home, the rate at which the average household saved their money skyrocketed and they’re now (on average — experiences with the pandemic are far from uniform) flush with cash.
Second, in the recovery from the pandemic while restaurants and travel are getting back to normal, people’s spending behaviours are not. The world has seen a massive boost in consumer spending on stuff, but much less on doing things. To put this simply, people aren’t going to the gym anymore, instead they bought a treadmill.
Raising interest rates ad infinitum won’t suddenly lower the cost of freight or make Putin back out of Ukraine.
Third, supply chains are well behind the curve. There are numerous logistical reasons why supply chains are struggling to get back to where they need to be — check out this UNCTAD paper if you’re interested. However, leaving that discussion to one side, the most important point to note is that over the pandemic, shipping costs went through the roof. Global freight rates have increased more than 400% since March 2020.
So, consumers have cash, they’re spending it on goods, and goods need to get shipped. It’s easy to see how all of this creates the mess we’re in now. There’s loads of demand, not enough supply, and moving stuff around is expensive. Add to this the effect that the invasion of Ukraine has had on oil and energy prices, and you’ve got yourself a cost-of-living crisis.
What’s being done?
At its May meeting, the Reserve Bank of Australia (RBA) raised the cash rate to 0.35%. At the press conference that followed, Governor Phillip Lowe said it was possible the rate could hit 2.5% — crucially noting that “how quickly we get there, and if we get there, will be determined by how events unfold” (more on that later).
Commercial banks like ANZ, NAB, Westpac, and Commonwealth pass on those increases in the cash rate to the interest rates paid by their customers, although the intricate mechanics of the cash rate matter less here than what it means for consumers.
This is the conundrum that the RBA is faced with: rates have to go up, but how much and how soon? …
We won’t know if inflation is passing or permanent until we do, but we still have to act.
If the RBA raises the cash rate, the most direct impact is that mortgages and other loans become more expensive. Repayments increase and more of a consumer’s budget is put toward paying down loans rather than spending. The idea is that if high consumer spending is fuelling inflation, raising the cash rate and, in essence, taking money off consumers will decrease spending and rein in price growth. Even if inflationary pressure is driven by impacts to the supply-side of the economy, the actual cause of inflation is an imbalance between supply and demand. In the absence of a capacity to boost supply, the only option is to curb demand.
Even if inflation is on the way out, this could take a few months. In the meantime, curbing demand will be crucial in ensuring that inflation doesn’t become embedded in the economy while conditions settle. Raising the cash rate and forcing many consumers to shift their spending away from goods to their mortgages will sap money out of the economy and relieve some of the pressure on supply chains by bringing demand into line with what the economy can actually provide.
While hitting consumers spending power will ease pressure, it won’t solve the underlying problems. Raising interest rates ad infinitum won’t suddenly lower the cost of freight or make Putin back out of Ukraine. It might do something, but if it cannot shift the international forces at play then raising them too high will simply punish consumers with no tangible effect on inflation. The risk, as many commentators are starting to note, is recession. If we hit consumers too hard, the consequence will be an economy in decline.
It is essential that the RBA projects the image that it’s on top of things.
This is the conundrum that the RBA is faced with: rates have to go up, but how much and how soon? If inflation has peaked, or if it will do so soon, then overreacting will not only be unnecessary, but disastrous. If inflation is embedded and this is only the beginning, then underreacting will be dire and extremely difficult to correct. We won’t know if inflation is passing or permanent until we do, but we still have to act.
Are we on the right track?
While the world waits for the conditions currently sustaining inflation to normalise the possibility that expectations start to fuel an inflationary cycle necessitates a boost in the cash rate. Such is the way of modern capitalism that projecting the image of the RBA as ruthless wielders of monetary policy is just as important as actually using said monetary policy appropriately.
While actual monetary policy is important, rhetoric matters just as much — if not more. An integral factor in the path of inflation is what people are expecting price growth to be over time. Financial markets, banks, and consumers all, whether consciously or not, take account of what they think prices will be in the future. If you need a new TV, for example, and prices are on the rise, you’re best off getting one while you still can. Alternatively, if you know there’s a sale coming up, it’s worth waiting.
With this in mind, it’s essential that the RBA projects the image that it’s on top of things. The announcement that it is ‘willing to do whatever is necessary to tackle inflation’ is intended as a signal to the economy that interest rates are going up, and inflation is coming down.
This also explains why Phillip Lowe is flagging that the cash rate could reach 2.5%, then immediately clarifying that this gives no indication of when, or any guarantee that it will reach that level. The headline is “RBA Governor Expects Cash Rate to Hit 2.5%” and this calms everyone down, but the substance is that they’re going to wait and see. As the bank stated on Tuesday, “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”.
The mistake is to commit wholeheartedly to a certain narrative — either that inflation doesn’t matter at all, or that we’re witnessing the beginning of the apocalypse.
This is, in my opinion, the right approach. Lowe has consistently asserted that the RBA is not committed to any single path and will remain responsive to changing circumstances. A sharp boost to the cash rate now — potentially to 1.35% at the July meeting — gives the bank time to read the room. Putting aside whether the bank should have raised rates earlier or that they shouldn’t have let them get this low in the first place, reacting to the evidence now is critically important.
Making constant, small increases that aren’t quite enough leaves the RBA behind the curve and risks losing the aura of control. Expectations start fuelling greater inflationary pressure which can only be contained by further rate rises. However, lifting the cash rate as quickly as the RBA has in the last two months sends a strong message that the bank is willing to do what is necessary and cools inflation expectations. Then, with expectations contained and consumers feeling the pressure, the bank could sit and wait to see if the evidence says inflation has peaked, or is at least trending down.
If it turns out that inflation is receding — either now or in a few months’ time — then jacking up the cash rate to the levels that financial markets are currently predicting will have disastrous consequences. However not acting at all would also have disastrous consequences. In both cases, the mistake is to commit wholeheartedly to a certain narrative — either that inflation doesn’t matter at all, or that we’re witnessing the beginning of the apocalypse.
What the evidence says at this point in time is that we’re experiencing inflation. That alone necessitates that monetary policy preempts expectations that inflation will continue by lifting the cash rate. On this basis, arguing that we don’t need to worry about inflation is dangerous.
The evidence also tells that inflation might be on the way out — freight costs are decreasing which is a sign that supply chains are stabilising. It also tells us that inflation isn’t embedded yet — wages are, in Australia, still growing at a normal pace and inflation expectations aren’t lifting in the medium-term. As such, arguing that we’re months away from double digit inflation and a wage-price spiral akin to the 1970s is irresponsible.
The fact is that we simply don’t know. Rather than prophesying about how the current situation will evolve, we should be hanging on for every piece of new information and reacting accordingly. Threading this economic needle will require balance, data, and openness to changing the plan.
