The Reserve Bank will need to lift the official interest rate at least twice more to ensure the “scourge” of inflation is contained, with the pace and size of increases determined in part by how fast wages pick up, the bank’s governor, Philip Lowe, has warned.
In a speech on Thursday, Lowe admitted the pace of inflation had caught the RBA and other central banks flatfooted. He said they had no choice but to lift the cost of borrowing to stop an “inflation psychology” from taking hold.
“The board expects that further increases in interest rates will be required over the months ahead,” Lowe told the Anika Foundation.
“But how high interest rates need to go and how quickly we get there will be guided by the incoming data and the evolving outlook for inflation and the labour market.
“The magnitude of the pickup in inflation has come as a surprise to everyone.”
Lowe’s comments follow Tuesday’s decision by the RBA board to lift the cash rate by another 50 basis points to 2.35%. The increase was the fifth in as many meetings and raised the benchmark rate to its highest since early 2015.
The governor, who has faced calls by the Greens and others this week to be sacked, said the bank was “committed to doing what is necessary to ensure that inflation returns to target over time”.
In comments after his speech, Lowe dismissed calls for him to go, saying: “I can assure you I have no plans to resign.”
He rejected suggestions he had broken a promise that the RBA would not lift its cash rate until 2024. Lowe said his remarks made in late 2021 were “highly conditional”.
“I did not promise interest rates would not go up until 2024,” he said on Thursday. “I know many people interpret my previous statements as saying that. But if you look back carefully, what we said was we thought the pandemic was going to have long-lasting effects on the economy.”
As it turned out, the pandemic improved “much faster than the advice we had and that others had”, Lowe said.
The central bank was keen to ensure higher inflation did not become entrenched, the governor said.
“High inflation is a scourge. It damages our standard of living, creates additional uncertainty for households and businesses, erodes the value of people’s savings and adds to inequality. And without price stability, it is not possible to achieve a sustained period of low unemployment.”
While the central bank didn’t get it right on inflation, neither did other economists, Lowe noted.
Philip Lowe says the RBA had a 'very big inflation surprise'...but they weren't alone. pic.twitter.com/VJjHI1UXXS
— Peter Hannam (@p_hannam) September 8, 2022
Lowe blamed the mistake of waiting to lift the cost of borrowing in part on the Russian invasion of Ukraine in February. The resulting increase in energy prices as countries imposed sanctions on Russia had jolted inflation higher, particularly in Europe, and contributed to rises in Australia.
“Analysis by the European Central Bank suggests that around three-quarters of the surprise in inflation in the euro area reflects unexpected developments in the markets for oil, gas and electricity,” Lowe said.
“In the UK, the Bank of England estimates that higher energy prices will directly boost CPI inflation by 6.5 percentage points this year.”
RBA's Lowe highlights the 20% increase in the cost of building a new home in the past year was among the uneven increases in prices. pic.twitter.com/bd5K7dUcJw
— Peter Hannam (@p_hannam) September 8, 2022
Lowe said that in Australia the 32% rise in petrol prices over the past year had directly added 1.2 percentage points to Australia’s CPI inflation.
The cost of building new dwellings had risen by more than 20% in the past year, as an example of uneven price movements that were not well picked up in broad models of demand used by central banks.
The shift in demand towards goods and away from services was another example of how different sectors of the economy behaved differently during the Covid waves.
Lowe makes the point that models of the aggregate didn't pick up sectoral changes as well as they should have. (eg During Covid times, goods vs services demand shifted significantly.) pic.twitter.com/UkDCWPYWNx
— Peter Hannam (@p_hannam) September 8, 2022
The psychology of inflation was something the bank was watching closely, Lowe said.
“Inflation expectations have picked up a little, but the measures derived from financial prices suggest there is a high degree of confidence that inflation will return to target [between 2% and 3% over the medium term],” he said. “This suggests that a pickup in inflation expectations is not a primary driver of the sharp rise in inflation.”
Lowe makes quite a bit about the importance of inflation expectations remaining low. So far, at least compared with the US, those expectations haven't shifted greatly - yet. pic.twitter.com/dtUPwQtxyR
— Peter Hannam (@p_hannam) September 8, 2022
How wages change will contribute to how expectations play out, Lowe said.
“If workers and businesses come to expect higher inflation, and wages growth and price-setting behaviour adjusts accordingly, the task of navigating that narrow path will be very difficult, if not impossible,” he said.
The US, for instance, has wages rising at 5% a year, well above their 2-3% inflation target, he said. Australia’s latest wage price index showed salaries were rising at an annual 2.6% pace in the June quarter.
“The main uncertainty we have is how the labour market is going to respond to this period of high inflation,” he said.
“I know it’s very difficult for people to accept the fact that wages are not rising with higher inflation.” But the alternative was that elevated levels of inflation would become protracted, requiring even higher interest rates later on and even more unemployment levels.
“And that’s going to hurt low-income people more,” he said.
Some economists suggested Lowe’s remarks indicated a likely slowdown in the pace of further rises.
“All else equal, the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises,” Lowe said in a comment highlighted by ANZ as a reason to alter its predictions on future rate increases.
ANZ still expects another 50 basis point rise in October but trimmed its November prediction to a 25 point rise. December should bring another quarter-point increase to 3.35%, senior economist Adelaide Timbrell said.
“There is a considerable risk the RBA could slow its hiking to 25bp in October, in which case we would expect an additional 25 basis point hike early next year, leaving the terminal rate at 3.35%.”
