An unsteady global financial sector has ratcheted up pressure on the Reserve Bank of Australia ahead of next month’s rate decision.
Facing the worst banking crisis since 2008, as well as record high inflation, the US central bank on Wednesday chose to continue its spree of rate hikes, raising interest rates by 0.25% – an uneasy compromise – but signalled that it may soon pause increases. Earlier in March, the European Central Bank raised its interest rate by 0.50%.
The RBA has raised official interest rates at a record pace over the past year, in line with its global counterparts. It must now, like them, steer a careful path between persistent inflation and potential upheaval in the banking sector.
Philip Lowe, the RBA’s governor, has argued there is no alternative because of the corrosive effects of inflation: “It hurts people, puts pressure on household budgets and erodes the value of people’s savings. It increases inequality and hurts people on low incomes the most.
“High inflation also damages longer-term economic performance, making the environment uncertain for planning and investing.”
But this policy position masks a few contradictions. For a start, the RBA has – since 2009 – sought to achieve an inflation rate of 2-3% on average over time. Ultra-low interest rates, massive injections of liquidity and encouraging bank lending have, in part, been designed to increase prices into the target range for several reasons.
The 2008 global financial crisis created fears of a deflationary shock – ie, falling prices. Deflation would increase the real value of debt because it would have to be repaid out of falling revenues and taxes. Economic activity would slow down as consumers deferred purchases because prices were falling.
Central bankers saw inflation as potentially useful, especially given the political gridlock in making necessary structural reforms: it would help manage increasingly unsustainable private and public debt levels and reduce debt as a percentage of GDP. Rising prices support economic activity; just as deflation slows spending, inflation increases consumption as people accelerate purchases, fearing that costs will be higher in the future.
Inflation also helps public finances and avoids difficult budget repair decisions. It boosts tax revenues because income tax scales are not indexed for changes in price levels and people are pushed into higher tax brackets. Government spending is also not generally automatically adjusted for cost-of-living increases. This means tax revenues increase more rapidly than spending.
Inflation rates also act through the currency: a higher rate of price increases can help devalue the currency, especially where real rates (adjusting for inflation) are low relative to other nations. This can assist in increasing exports and improving Australia’s international competitiveness.
A decade of rate cuts, while in line with global economic orthodoxy, has contributed to the current bout of inflation. Low rates and abundant money boosted demand, with the major initial effect being higher house prices, which fed into higher costs of living in the form of mortgage debt or rent.
When inflation accelerated in 2021-22 due to supply side factors exacerbating demand, the RBA was forced to reverse course. The rate rises exposed a fundamental problem – the creation by central banks of an economy and financial system built around artificially cheap money. This had led to overstimulated segments of the economy and encouraged leverage and speculation on an epic scale. Central to this were asset price bubbles in property, shares and venture capital around crypto and new technologies. The architecture was neither sustainable nor costless.
Now, higher rates threaten to bring down the whole edifice. Alongside the crypto crash (cost approximately $3tn), the technology meltdown (around $7tn), the UK gilt crisis (perhaps around $670bn) and the ongoing emerging market debt crisis is a potential banking crisis that might have only begun, creating new challenges globally.
Strong employment and ongoing price pressures dictate that the RBA may continue to tighten monetary policy and increase rates, or at least keep them high. But the problems of financial instability require the exact opposite. If it cuts rates, then there is a risk inflation will remain above the desired level, inflicting long-term economic damage. Like its overseas counterparts, the RBA is now facing an impossible choice.
Higher rates coming after a prolonged period of cheap money predictably destabilised the system. Policymakers are discovering that addiction to easy money – like all addictions to oversimplistic and artificial solutions that do not deal with the real underlying cause – is ultimately futile and destructive.
Paraphrasing the hackneyed joke, if you want to normalise conditions and create a sound economic and financial system, I wouldn’t start from here!
Satyajit Das is the author of Fortune’s Fool: Australia’s Choices and A Banquet of Consequences – Reloaded
