Interest rates have risen again, in a move that could sink the housing market and even put the economy at risk, as the RBA battles high inflation. But the rate hike cycle is far from over.
Official interest rates rose half a percentage point to 1.85% on Tuesday as the RBA’s board met in Sydney to discuss a way to stamp out rapid price rises and generalized.
“The increase in interest rates over the past few months has been necessary to bring inflation back to target and to create a more sustainable balance of supply and demand in the Australian economy,” the RBA governor said in a statement.
“The [RBA] The Board is committed to doing what is necessary to ensure that inflation in Australia returns to target over time.
Rates rose extremely rapidly, from 0.1% at the start of the year to 1.85% as of Tuesday, and certainly did not peak. They could increase much more if certain predictions are true.
What predictions should we pay attention to? Talking is cheap, but some people put their money where they say it, in the interest rate futures markets. These markets expect rates to rise to a peak in March 2023 at just over 3%. It looks like a lot more rate hikes to come, but as the next chart shows, forecasts from not too long ago called for even more aggressive rate hikes. Recently, expectations have become more subdued and even suggest a rate cut in the second half of 2023.
Inflation: the old enemy
Defeating inflation has been one of the great triumphs of economic policy over the past 30 years. Now, with fuel over $2 a liter and lettuce over $9, that victory is in jeopardy.
The word inflation refers to persistent and widespread price increases. High inflation is considered bad, especially because it erodes the purchasing power of savings. If you had $1,000 in the bank a year ago, it now buys about 6% less thanks to our 6% inflation over the past year. Inflation hurts everyone who has money saved, such as pensioners (although it helps anyone in debt, because the real value of debt goes down).
But the reason we fear inflation goes deeper than that. When inflation sets in, it changes inflation expectations. Anyone who negotiates for wages demands a high percentage increase every year, and those higher costs translate into higher prices, and we can get stuck in an inflationary spiral. No one is doing better, but the prices keep going up. Then the only way to bring inflation down is to really crush the economy. The RBA’s hope is to get inflation under control before inflation expectations rise permanently and without sending the economy into recession, a challenge the governor called a “narrow path.”
Prices are soaring
The job of the RBA is to control inflation. It is a failure, as the following graph shows. Inflation has moved well above the target range of 2-3%.
Why does inflation happen?
A business will raise its prices when it has more customers than it can supply. Think of a tradesman whose phone breaks down. As a result, he will add 10% (or more!) to all his quotes.
If a lot of companies are in this situation, they all increase their prices and we get generalized inflation. Then the RBA steps in, raising interest rates. This has three main effects, all of which aim to reduce the need for companies to raise prices:
- Households have less money to spend because people have to put more money on their mortgage.
- Businesses spend less because the cost of borrowing is higher.
- The “wealth effect”: when interest rates rise, property prices fall, people feel less wealthy and spend less.
You’ll notice one thing in common about the above: making Aussies feel poorer so they spend less. Yes, fighting inflation is painful, which is why we want to control it above all.
There are a few other ways monetary policy works, which also involves generating less spending in Australian businesses.
- People save more when interest rates are higher. If they save more, they spend less.
- The exchange rate rises when interest rates are higher, making imports cheaper and domestic goods more expensive in comparison. (It works in theory, but right now most central banks are raising their interest rates. And some are rising much faster than Australia, so our rate hikes are probably keeping our dollar from weakening, not not actually reinforce.)
- When house prices fall, fewer houses change hands, and we spend less on realtors and haulers, movers, and furniture (moving usually forces people to buy new things).
All six reduce the amount of money Australians spend on domestic businesses. It’s no fun for anyone – it makes things difficult for households and businesses.
Will it work? This will be the case if the problem is the one I described above: that they “have more customers than they can supply”.
But of course, right now, a lot of the inflation is in import prices. Putin has upended the world wheat and oil markets with his war, and the prices are exorbitant. Crushing Australian household budgets with huge mortgage repayments isn’t going to change the dial much on gasoline prices, for example. So there’s reason to be skeptical about whether the RBA can really bring inflation down quickly, even if it raises interest rates as quickly as expected.
The “narrow path” the RBA finds itself on might actually be more of a tightrope walk.