Stormy waters Everyone, from the Reserve Bank to economic commentators, has reached a consensus that Australia is in for a sustained period of increasing rates, writes John Kehoe.
The global inflation wave has washed on to Australia’s shores, right in the middle of the federal election.
The price pressures and looming interest rate rises have exposed that the Coalition and Labor do not have a serious economic plan to deal with inflation. Rather, the government is pouring another $5.6 billion of ‘‘cost of living’’ cash hand outs and tax refunds on to the inflation bonfire.
The election pork will add to inflation pressures that have been underestimated by both the Reserve Bank of Australia and Treasury. The RBA boldly declared at the start of the pandemic that inflation would not be sustainably high enough to lift the 0.1 per cent cash rate until at least 2024 and last December said the market should not expect rate rises in 2022.
But times have changed. Inflation hit 5.1 per cent in the March quarter, the highest annual rate since the 10 per cent goods and services tax was introduced in 2000-01. Wholesale electricity prices have doubled over the past year and will soon begin flowing through to retail power prices, due to the soaring cost of coal and gas triggered by the war in Ukraine.
The government rightly points out much of the price pressures are due to international forces out of its control, including war driving up the global oil price and supply chain disruptions from the pandemic, particularly in the manufacturing hub of China.
Nevertheless, home-grown price pressures are also building due to strong demand from cashed up consumers and the economy running near full capacity, as evidenced by a firming in inflation of non-tradable items and services. Food, housing, transport and education prices are rising.
The RBA will soon begin raising interest rates, either next week or in early June, and keep raising the cash rate in the months ahead. It is a welcome development that the cash rate will finally be lifted from an emergency low of near-zero. The economy, with a low 4 per cent unemployment rate, has rebounded from the pandemic due to $314 billion of federal government stimulus.
To be sure, controlling inflation is predominantly the remit of the independent central bank. But despite economic management rhetoric from the government and cost of living complaints from Labor, neither side of politics is offering a comprehensive economic policy plan to contend with inflation and productivity.
Dan Andrews, a former Treasury, RBA and OECD official, says, “if the inflation tide has turned, then the imperative is to boost supply via productivity improvements”.
“The chickens are coming home to roost,” says Andrews who is now program director at the e61 Institute. “The supply side productivity agenda has been neglected for some time. Reforms matter now more than ever given that inflation typically arises from strong demand pushing up against supply constraints in the economy.”
To lift chronically weak productivity growth of the past decade, economists nominate reforms to the tax system, boosting competition against incumbent firms to allow the growth of more innovative firms, improving energy and climate policy to lift investment, enhancing workplace relations and labour mobility, and better regulation to reduce red tape barriers. But these areas are largely off the table among a political class that believes voters are not up for a difficult national conversation.
There is also no plan from the Coalition or Labor to rein in structural budget deficits which will further fuel demand pressures in the economy if inflation persists more than previously thought. Barrenjoey chief economist Jo Masters says: “There is no real talk of any serious reform and everyone is small target on the economy.” She adds: “The inflation cycle makes it imperative to lift real wages through productivity-enhancing reforms.” And: “Economists are exhausted talking about it.”
Labor’s economic plan this week pledged more spending on childcare, aged care, clean energy and to support pay rises for aged care workers, while unveiling a modest $5 billion in savings over four years on ‘‘waste and rorts”. Shadow treasurer Jim Chalmers argues cheaper childcare will reduce family costs and inject more productive female workers into the workforce.
The Coalition is largely running on the economic performance during the pandemic, with little new policies. The 22.1c a litre petrol excise cut for six months, while politically understandable when prices were above $2 a litre, will only artificially and temporarily reduce inflation.
More than half of businesses have experienced cost increases over the past three months and a majority of firms passed price increases on to their customers, an Australian Bureau of Statistics survey reported this week. Coles chief executive Steve Cain says he is receiving price rise requests from suppliers. Moreover, the two-year closure of the international border and broader pandemic concerns have reduced the flow of labour around the world. Unions and workers are starting to demand larger pay rises, to catch up to inflation. Outlook Economics director Peter Downes says the low 4 per cent unemployment rate is starting to generate wage pressures, a factor the RBA would be picking up in its business liaison.
RBA governor Philip Lowe in early April signalled he would like to see both inflation and wages rising before lifting the 0.1 per cent cash rate. The next wage price index print is due on May 18 and average earnings data in the national accounts on June 1.
If Lowe holds true to his public statements about the bank’s “reaction function” being wages, then a pre-election rate rise is not on, and the RBA would wait until June. Treasurer Josh Frydenberg publicly reminded the RBA of this framework this week – a move Chalmers said undermined the independence of the central bank.
But the big 5.1 per cent jump in annual inflation and 3.7 per cent rise in underlying inflation will force the RBA to consider moving the first rate increase forward to next week. A gentle 0.15 of a percentage point rise to 0.25 per cent is a live option.
Outlook’s Downes says: “There is no point waiting any longer.” He adds: “Knowing what we know now, they should have started raising rates at the start of the year. The longer the RBA waits the higher they will have to raise rates later.”
He says Australia can and should avoid repeating the ultra-high 8.5 per cent inflation rate of the United States “without having to raise rates too much”.
Money market traders have priced in a 2.5 per cent cash rate by the end of the year, implying rate rises every month for the rest of the year.
Commonwealth Bank of Australia economist Gareth Aird argues high household debt levels will limit RBA increases to about 1 per cent by December.
The Morrison government would obviously prefer the RBA wait until after the election to raise rates, while Labor would welcome a pre-election rate rise to drive home its cost of living pitch to voters.
But sensing the RBA might move next week, the government has warned that the economic uncertainties caused by inflation and rate rises mean now is not the time to risk handing the economy to an inexperienced Labor government.
Morrison also makes the point that it’s very different to when the RBA raised rates in the 2007 election campaign – a move that upset then prime minister John Howard and treasurer Peter Costello. Back then rates were already at 6.5 per cent and Howard had pledged to keep them low. .
Andrews recalls the RBA’s interest rate hiking cycle in 1994, when the RBA raised the cash rate from 4.75 per cent to 7.5 per cent in six months. Then, Australia was on the cusp of a productivity boom thanks to the internet revolution and economic reforms of the Hawke-Keating governments in the 1980s and 90s. Andrews says productivity was one of the factors why the RBA didn’t keep hiking rates beyond 1994.
“That expanded the speed limit of the economy and inflation was brought under control,” he says. “We’re in a very different place right now because we haven’t done substantive structural reform.”
