A series of interest rate rises caught Australians off guard. Dr Timo Henckel explains what caused them to go up, the link to inflation and whether we can expect interest rates to fall.

The Reserve Bank of Australia’s (RBA) decision to raise or lower the official cash rate has far-reaching impacts. But what factors play into those decisions? What’s the connection to inflation rates? And how high will interest rates rise?

In May 2013, the RBA dropped the official cash rate to what was then a record low of 2.75 per cent.

Over the next few years the cash rate continued to drop further, reaching its lowest point, 0.10 per cent, in November 2020. It remained there through much of the COVID-19 pandemic, as the central bank tried to encourage job growth and economic recovery.

Then in May 2022, the RBA lifted the rate by 25 basis points, stating it was the “right time” to start withdrawing some of the monetary support put in place during the pandemic. It was the first time the cash rate had risen in nine years.

By March 2023, there had been 10 consecutive rises, taking the cash rate to 3.60 per cent – its highest level since May 2012

Economist and chair of the RBA Shadow Board at The Australian National University (ANU) Dr Timo Henckel explains the thinking behind the monthly movements and what the RBA is trying to achieve.

Why does the RBA lift or lower the cash rate?

If you look at the RBA charter, there are three national economic policy objectives. The one we arguably tend to focus on most is keeping the inflation rate within the official target range of two to three per cent (formally, to ensure “the stability of the currency of Australia”).

But it doesn’t have to do that at every point in time. It’s perfectly acceptable for the inflation rate to occasionally be outside that target range. The assumption is the RBA will be able to bring it back into that target range eventually. This is merely an acknowledgment that the RBA does not exercise perfect, and instantaneous, control over prices in the economy.

One of the RBA’s objectives is to keep the inflation rate within a target range. Photo: eyeofpaul/stock.adobe.com

There are a couple of other objectives, including the maintenance of full employment and the pursuit of economic prosperity and welfare of the people of Australia. Sometimes those different objectives are aligned and other times they’re not.

The complication is that monetary policy has very long and variable lags. So when the RBA changes its interest rate now, for example, it’s not going to work its way through the economy for quite a long time.

It’s like trying to steer a supertanker. When you steer a ship and turn the wheel, it’s not like the ship turns straight away. There’s just so much momentum going in that original direction that it takes a while for the ship to change course.

Ultimately, the RBA is looking for that ‘Goldilocks’ level of economic activity, which should also mean that inflation is within the target range. Barring any shocks, if the economy is just humming along, the RBA will be happy to leave everything as it is and keep its hands off the interest rate levers.

What can the RBA do about inflation?

If the inflation rate is rising, the RBA will try to identify what’s driving it.

If it’s likely to be just a temporary blip, the RBA is probably not going to do anything. For example, if the inflation rate goes up because banana prices have gone up really high in response to a cyclone in Queensland, we know that’s not really something the RBA should be concerned with because prices will come back down when the crop recovers.

Identifying the source of changes in the inflation rate, such as the impact of natural disasters on the price fruit and vegetables, is important. Photo: Dan Dalton/KOTO/stock.adobe.com

But if the RBA thinks inflation is going to be high and remain high for some time, then it needs to act.

If inflation is high because there’s a general boom, then the RBA wants to rein in demand so that spending falls and output returns to a healthier level and inflationary pressures reduce a bit as well. This is a situation in which both output and inflation are too high; reducing inflation by contracting output (growth) does not involve a costly trade-off.

When the shocks are not primarily on the demand side, but on the supply side, then it becomes much more problematic. This is a situation in which inflation is too high but output is too low. The central bank can try to reduce inflation but at the expense of a further drop in output, or it can try to stimulate output (growth) accepting a higher inflation rate. The two objectives – reducing inflation and increasing output – now do involve a costly trade-off.

So identifying the source of the shock is really important and really hard.

The situation is exacerbated if the public expects future inflation rises as these become self-fulfilling: if workers expect higher prices, they will demand higher dollar wages, and if firms expect higher prices and wages, they will raise their prices so as to preserve their profit margins. This wage-price spiral, when inflation expectations become entrenched, are a central bank’s nightmare, because permanently reducing the inflation rate typically requires a painful economic contraction.

Why has inflation risen in the past year?

At the moment, we have both supply and demand shocks. There’s a little bit too much demand, but there’s also a supply problem.

The demand ‘shock’ afflicting the Australian economy right now is essentially a resumption of economic activity following the pandemic when households and firms reduced their spending and increased their savings.

The pandemic caused a drop in output and demand. Photo: FiledIMAGE/stock.adobe.com

At the same time, there are still bottlenecks from the pandemic, interruptions to global trade and supply networks, the war in Ukraine, and geopolitical issues in general, which have all created some supply issues. Domestically, as well as the direct fallout from the pandemic, we have a major restructuring of the labour market: people’s work habits have changed and they are not returning to the same positions as before.

So, there are several factors constraining the supply side, it’s not the way it was a couple of years ago. This is a problem because costs and prices are increasing but output is not. We are in the second world described above, in which there exists a costly trade-off between the inflation and output targets.

How does raising interest rates curb inflation?

There are multiple ways in which an increase in the interest rate is supposed to bring down inflationary pressures. The most direct is that it increases borrowing costs.

We know that a lot of spending requires or relies on borrowing. Households will borrow in order to spend, not just on houses but also on other items, for example, consumption goods.

Also, many firms don’t have all the requisite funds when they invest, so they borrow. If borrowing costs go up, they tend to invest less and that’s less spending in the economy, which is going to reduce the overall pressure on prices.

In reality, there are additional channels through which monetary policy works. For example, an increase in the domestic interest rate tends to raise the value of the Australian dollar as it becomes more attractive for international investors to put their money in Australian dollar denominated assets.

A higher Australian dollar reduces import prices, which lowers the consumer price index (as it includes imported goods and services). At the same time it makes Australian-made goods and services more expensive and overseas goods and services cheaper so that net exports decline, slowing the domestic economy.

Why did the RBA start to lift the cash rate last year?

The pandemic was essentially both a negative supply and demand shock. If it was a negative supply shock on its own, then that would suggest inflation would go up and output would fall as a consequence.

But if it was a negative demand shock on its own that would suggest that output would fall and inflation would fall.

Given both sides were working together, it was clear that output was going to fall, but it wasn’t clear whether inflation was actually going to rise or fall or remain about the same because the two shocks give you a different outcome on inflation.

By virtue of the long and variable lags, when the RBA makes decisions on monetary policy it is looking ahead to where it thinks inflation is going to be in 12 months, 18 months, two years, and then it bases its decision on that. Obviously those forecasts are never going to be perfect and it can get those wrong.

The RBA has come under criticism and the argument is that they let inflation rise too much and now they’ve possibly responded too late.

At the end of 2021, it was clear inflation was looking too high, but many analysts, including the RBA, thought it was going to be temporary; once those bottlenecks associated with the pandemic eased, inflation was expected to come back down. So the RBA, and other central banks, did not act.

However, at the beginning of last year, their sentiment changed and the RBA it’s probably not just a temporary increase in the inflation rate, but is likely more persistent.

Recent rate rises are part of a “normalisation” of interest rates. Photo: Taras Vyshnya/stock.adobe.com

The million-dollar question: when will interest rates go down?

To hope, or advocate, for interest rates to go down, suggests they were in the right place when they were previously very low. It’s important to realise that’s not the case.

Historically, interest rates were never as low as 0.1 per cent and staying around that level for so long was highly unusual.

Much of what’s happening now is part of a normalisation of interest rates.

Among economists, there’s a view that the ‘Goldilocks’ level – where the economy hums along at a sustainable rate and inflation comfortably sits within its target range – is associated with what is often referred to as a ‘neutral’ interest rate. That neutral interest rate is probably somewhere between three and four per cent, although there is a reasonable amount of disagreement about its exact magnitude.

We shouldn’t assume interest rates are going to fall to near-zero over the medium-to-long run again, unless there is another really bad economic shock that makes the RBA want to dramatically change course.

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