Alarm bells ringing on more interest rate pain

Blame the latest rate rise on a loss of faith in the promises of a Labor government and a divided Reserve Bank board to get inflation under control.  

Plenty of housing borrowers will wonder why a split Reserve Bank is responding to higher prices at the petrol pump by forcing them to increase their mortgage repayments. 

Doesn’t this simply risk smashing the economy, as Jim Chalmers has previously complained, just as motorists reel from higher oil prices?   

Some commentators similarly will argue that Iran’s blocking of about quarter of the world’s seaborne oil from the Persian Gulf is a so-called supply shock. 

But monetary policy cannot pump more oil or reopen shipping lanes.  Interest rates mostly work on influencing demand, not supply. 

Both housing borrowers and these commentators normally would have a point. Usually, central banks ‘look through’ what are hoped to be temporary inflation shocks.  

But RBA governor Michele Bullock now has jacked up her cash rate by 25 basis points for the second month in a row because of two words that can strike fear into the heart of central bankers: “inflation expectations”. 

After not being a concern for the past two years, Tuesday’s RBA board statement suddenly explicitly refers to inflation expectations in four of its nine paragraphs. 

Australians were losing faith that the combination of Labor’s economic policies and the RBA monetary policy would tame inflation even before Donald Trump and Benjamin Netanyahu started bombing Iran’s theocratic dictators.   

Labor’s big spending care economy — led by the out-of-control NDIS — has pumped up overall demand in the economy.  

Combined, the expansion of the low-productivity care economy, the union-friendly reregulation of the job market and the high-cost clean energy transition also has smashed the Australian economy’s supply capacity.  

Even before the Iran war, the RBA figured that overall demand in the economy was exceeding its capacity to produce more goods and services.  

The RBA’s pointy heads figure that the economy can’t post better than a mediocre 2 per cent real annual growth rate without running into supply bottlenecks. When even modest demand growth exceeds supply capacity, the result is higher prices.  

Even after the RBA’s 13 cash rate hikes over 2022 and 2023, annual inflation is running at 3.8 per cent — too far above the central bank’s 2-3 per cent target. 

More than other comparable economies, falling inflation stalled and “sprung up again” last year.  

Bullock sounded the alarm just three days after the American and Israeli bombs started falling on Tehran.  

Inflation remained Australians’ top concern, “perhaps unsurprising given inflation has been elevated for some time”, she said.  

Soaring petrol prices would likely push inflation up to 5 per cent or so, feeding into higher business costs. And, the longer inflation stayed above target, the more people would expect it to stay there.   

The central bankers’ nightmare scenario is that the inflation expectations of business price-setters, workers and investors become ‘unanchored’, as already shown in rising bond market yields.    

If inflation expectations ratchet up, they could become self-fulfilling, further feeding the inflation dynamic.  

Worse still, the RBA would lose its most precious asset: the credibility of its promise to keep inflation low.  

Before this week’s board meeting, the RBA was behind the inflation-fighting curve on inflation compared to other central banks when the Iran war hit. Its cash rate was effectively zero in real terms while the jobless rate remained at a close to 50-year low of 4.1 per cent.  

Neither Labor nor the RBA board could have predicted the Iran War. But, as Bullock has stressed, the world has moved to an era of supply side shocks since Russia’s early 2022 invasion of Russia.  

Labor’s roughing up of the RBA inevitably has eaten away at its inflation fighting credibility. Now that risks being exacerbated by the board’s public 5-4 per cent spilt decision to increase the cash rate again. 

That now risks further increasing the pain that mortgage borrowers will have to bear to finally tame inflation.     

Michael Stutchbury is Executive Director of the Centre for Independent Studies.