Australia’s politicians and Reserve Bank officials have obfuscated the extent of the economic challenges ahead.
The spin is that interest rate rises are temporary and for the best. The truth is that the cost of living and interest rates may stay high for some time to come.
Recent moderation of inflation reflects declines in volatile oil and food prices. Governments are trying to buffer households from these costs. Europe alone has spent €800bn (A$1,250bn) to shield consumers from high energy prices.
But a fall in inflation alone will not bring down the cost of living. Inflation measures change: a petrol price rise from $2.00 per litre to $2.20 equates to 10% inflation. If it stays at $2.20, then inflation falls to 0% but the cost of petrol remains high and unchanged.
There are two main factors that may keep the cost of living and interest rates high for longer than anticipated.
Supply and scarcity issues
As the RBA’s own research shows, current inflation is being principally driven by supply issues.
Policymakers have limited influence over input costs. Energy prices reflect the Ukraine conflict and sanctions targeting Russian oil and gas exports. Trade restrictions continue to disrupt the production of many goods – especially US actions to restrict the supply of certain technology to China (the world’s factory).
Long-term resource scarcity concerns loom. Shortages of water, food and non-renewable raw materials are likely because of rising demand, supply constraints and inadequate investment.
Copper, lithium, nickel and cobalt production will struggle to meet the requirement of the energy transition. Part of the problem is geology. Nickel, lithium, cobalt, and copper make up 0.002% to 0.006% of the earth’s crust compared to iron (5%) and aluminium (8%). An overlooked factor is declining yields. Energy extraction costs are rising due to accessible sources being exhausted. The average grade of copper mines is about 0.5% today, well below the 2.5% 100 years ago.
Climate change is having a growing impact. Higher food prices are likely, especially periodic spikes due to weather events. Interruptions to supply, production and transport are increasing. The climate crisis is already having an impact on insurability, and increasing disaster relief costs. Extreme weather is costing every Australian household an average of more than $1,500 annually.
The retreat from globalisation and the reassertion of national sovereignty pushes up costs further. Reshoring or “friend shoring” is less efficient and leads to more expensive goods and services.
An ageing population creates worker and skill shortages and drives higher labour costs. Slowing productivity improvements limit the opportunity alleviate cost pressures.
Policy confusion
When it comes to inflation, policymakers have limited options.
Increasing interest rates cannot increase supply and only reduces demand. Although slowing, household consumption remains high due to strong labour markets (unemployment is at its lowest for a long time). In most developed countries, government spending, particularly where there is an ageing population, pushes up costs where supply is constrained. The complex trade-off between economic activity and inflation means politicians and central bankers are pulling in different directions.
In reality, rates would have to increase much further to be effective. Despite rises, real rates (interest rates minus inflation) remain negative. This means borrowers continue to pay historically low rates which do not properly compensate savers for the loss of purchasing power of their money due to inflation.
A prolonged period of higher rates risks a recession without bringing prices down, and governments cannot offer much cost-of-living relief spending to offset the slowdown because of debt concerns. It might force central banks to increase rates even more.
Decades of low interest rates and ample liquidity helped increase asset prices, particularly for housing. This has led to higher mortgage debt and rents, which feed into inflation. Raising interest rates may trigger large falls in house and share prices, which act as collateral for mortgages and other borrowing. This risks a banking crisis as well as exacerbating any slowdown in economic activity as the loss of wealth results in less spending.
The risk of policy mistakes is high. RBA officials want us to trust that they can pilot the economy to a “soft landing”. But these same individuals created the conditions for inflation through loose monetary policy, and said inflation was transitory, and forecast that interest rates wouldn’t rise until 2024!
The decades of low inflation that preceded the recent spike was not due to sound economic management, but a favourable confluence of circumstances: globalisation, low commodity prices and benign geopolitical conditions. These elements are now simultaneously in reverse.
The return of inflation and higher rates merely strips away the wallpaper covering deep-seated underlying problems. The correction taking place was inevitable. It will take time and be painful for many. Households need to reacquaint themselves with the safety instruction booklet as to how to adopt the emergency “brace” position.
Satyajit Das is a financial consultant and former banker, and the author Fortune’s Fool: Australia’s Choices and A Banquet of Consequences – Reloaded
