For several months now, the Reserve Bank of Australia (RBA) has been communicating that, when it comes to interest rate policy, it would rule nothing in or out. The message was that inflation was slowly heading back to target and the RBA was prepared to be patient. It did not want to speed up the return to lower inflation at the cost of pushing Australia into recession. Both upside and downside risks meant a higher than usual level of uncertainty, but these were roughly balanced.
We have always known that returning inflation to target was going to be a difficult act. In the past, episodes of high inflation have typically been dealt with by recession, including the now infamous “recession we had to have” in the early 1990s. The RBA has talked for a long time about a “narrow path”, which the current governor, Michele Bullock, worried a few months ago had become even more narrow. Achieving a “soft landing” was always going to be something of an economic miracle.
After the August RBA board meeting last week, however, that miracle seemed to move further out of reach, as the RBA’s message shifted quite sharply. Instead, we were told that a rate cut before Christmas – expected by many economists (including this one) to be necessary to deal with anaemic growth and rising unemployment – was being ruled out.
The bank’s shift to a more hawkish tone seemed particularly surprising given the relatively benign June quarter inflation numbers, reported just before the board meeting. “Underlying” inflation – the rate that the RBA watches most closely – nudged down once again and was in line with earlier RBA forecasts.
And yet Bullock told a press conference immediately after the rate decision was announced that the board had seriously discussed a rate increase.
So, what changed?
The bank noted that “inflation is still too high because demand is still too strong” and that “there is still a risk that inflation will take too long to return to target”. Curiously, although the RBA’s latest growth forecasts for the year ahead are now stronger, the inflation and unemployment forecasts are not significantly different to those published in May.
On the face of it, it’s not the economic conditions that have changed much, but perhaps the RBA’s tolerance for those conditions given prevailing risks.
The idea that the economy is running too fast grates for many people, particularly the two-thirds of Australians paying higher mortgages and rents, in addition to the increased cost of food and other essentials. The bank itself notes that people have had to reduce their “non-essential” spending.
And while the bank may be concerned about what dentists, vets and hairdressers are charging, the biggest drivers of price increases are coming from new housing and rents, insurance and energy. But raising interest rates is not going to help address these issues and may even make them worse.
Of course, the RBA might decide that it will go harder on the things that it can control to get overall inflation down faster, but that would be a brave decision. Bullock has also called on governments to look to their spending but, outside of Queensland, it would not be fair to suggest that fiscal policies are massively expansionary and no one is going to cut their welfare or infrastructure spending ahead of elections.
Feeding into RBA concerns is a more pessimistic view on the labour market. The numbers haven’t changed, just the theory of how this might play out, particularly given weak productivity growth.
But we’ve just been through a period of historically low unemployment without wages spiralling as they did in the past (when unionisation rates were almost 50%, compared to the current 12.5%). And unemployment is rising from lows not seen since the 1970s.
Now at 4.1% and forecast by all, including the RBA, to go higher, cracks are appearing in the labour market, which the Treasury secretary, Steven Kennedy, noted in a speech back in May. If we are looking for risks to the economic outlook, we must also factor in a weaker labour market.
We saw what that risk could look like in the US recently, where a lift in the unemployment rate from 4.1% in June to 4.3% in July was enough to spark fears of recession and a massive sell-off in equity markets and increased expectations of an imminent rate cut in the US. Another key driver of pessimism has been the run down in savings built up over the pandemic period.
In Australia too, savings have returned to more normal levels, indicating consumers can no longer rely on their piggy banks to help with their bills, although they will have tax cuts to help somewhat.
Globally, we’ve seen rates fall in recent months in the UK, Canada, China, Eurozone and Switzerland, with New Zealand and the US expected to join the ranks soon. Monetary policy is working albeit with longer than usual lags. Australia is not so different.
In its Statement on Monetary Policy, the RBA canvasses a number of upside and downside risks to inflation. Yet, in public comments, the bank has emphasised those that threaten the inflation outlook, rather than those that risk weaker growth and higher unemployment.
Whatever is driving the decision to shift to a hawkish stance and to effectively rule out a rate cut this side of Christmas, it’s not clear that the balance of risks supports this sudden change of heart. And it seems that the lessons of the past on issuing “forward guidance” have been quickly forgotten.
Nicki Hutley is an independent Australian economist and councillor with the Climate Council
