Pearls and Irritations

The Reserve Bank has explicitly warned against any expectation that interest rates will start to fall soon. On the other hand, the Treasurer recently claimed that the Reserve Bank is smashing the economy, implying that interest rates should fall soon. Who is right?

Interest rates have risen exceptionally rapidly over the last two years, with the Reserve Bank’s cash rate increasing 13 times between May 2022 and November 2023 from 0.1% to 4.35%. This, of course, was in response to an unacceptable rate of inflation which peaked at 7.8% over the four quarters ending in December 2022. Now inflation is falling in response to the increase in interest rates, and the latest data show inflation increasing at an annual rate of 3.8% over the four quarters ending in June 2024, while the Reserve Bank’s preferred measure of underlying inflation — the trimmed mean — increased by 3.9% over that year.

Although the inflation rate is still running above the Reserve Bank’s target range of 2-3%, the critical question now being asked is when will interest rates start to come down?

The Reserve Bank, for its part, has stated that it does not expect inflation to be back in its target range until the end of 2025 and to only approach the midpoint in 2026. Based on these forecasts, it has counselled “it is premature to be thinking about rate cuts” and implied that we should not expect any cut in interest rates before sometime in the first half of next year at the earliest.

On the other hand, last week Treasurer Jim Chalmers argued that the Reserve Bank was “smashing” the economy, with the implication that interest rates should start to come down sooner rather than later, and probably this calendar year. Also, as Ian McAuley pointed out in his Weekly Roundup for 3 August, these annual inflation rates that the RBA is relying on are heavily influenced by the rate of inflation six months ago. If instead we take a three-month moving average of the monthly CPI data then inflation is already back down in the RBA’s comfort zone.

Chalmers was, as usual, immediately attacked by the Opposition and its media supporters, but that begs the question: what would they do instead? Peter Dutton and Angus Taylor refer blandly to how major cuts in public spending are necessary if we want to reduce inflation sooner while relying less on interest rate increases. In principle, lower public spending is a legitimate way to reduce inflation, but the Opposition never spells out where and how it would make these cuts, let alone what would be their impact on our well-being.

The question to be explored further in this article is, therefore, who is right and when and how interest rates should come down.

The Reserve Bank’s position: how strong are their arguments?

As the RBA itself has acknowledged many times, there is a narrow path if we are to bring inflation down while avoiding a recession.

However, as the RBA sees it, inflation is still too high, and on the other hand the economy is still continuing to grow. Demand is continuing to put upward pressure on inflation, according to an RBA Assistant Governor, Sarah Hunter, when she appeared in front of a Senate Committee a couple of weeks ago. Nevertheless, GDP only grew by 1.0% over the last year and GDP per capita has been falling for the last six quarters.

The other critical indicator that guides the RBA is the unemployment rate, and more generally the strength of the labour market. As Governor Michelle Bullock put it in a speech last week, “the Board is looking to strike an appropriate balance between the RBA’s inflation and full employment objectives.”

However, when considering that balance, the RBA is still heavily influenced by the experience of inflation back in the 1970s and 1980s. As Bullock reminded us in her speech, inflation as measured by the CPI, reached 17.7% in March 1975 and it remained around 10% for the rest of the 1970s and early 1980s. Furthermore, expectations about future inflation took off, resulting in a wage-price spiral which made it very difficult to bring inflation back down without a recession.

In response to that experience, for a long time RBA monetary policy decisions relied heavily on the Phillips curve which purported to show the relationship between the level of unemployment and the rate of inflation of both wages and prices. Thus, the Bank targeted the NAIRU which was defined as the rate of unemployment consistent with achieving its inflation target.

However, the RBA has been slow to recognise and appreciate how changes in the labour market can affect the NAIRU and the shape of the Phillips curve. Consequently, the RBA persistently overestimated annual wage growth by about 1 percentage point every year between 2011 and 2019. Nevertheless, throughout that period the Bank staff continued to suggest that the NAIRU had changed little and was still close to 5%. Then in mid-2019 the Bank announced that it had revised its estimate of the NAIRU to 4½%.

Today the Bank no longer talks about the NAIRU specifically, but it seems very likely it still thinks unemployment is, if anything, too low and needs to rise if inflation is to be brought back down into its target range of 2-3%. For example, in her speech last week, Bullock stated that “the labour market remains relatively tight”, whereas it is arguable that it has eased. Also, it is likely that the NAIRU has fallen further below 4½% and that labour demand is already now too low to sustain the present inflation rate.

The Labor Government’s position

Contrary to the Opposition’s criticisms, the government’s fiscal policy has broadly complemented the RBA’s efforts to tighten monetary policy, thus reducing demand and helping to bring inflation down. In both its first two budgets for 2022-23 and 2023-24 the Albanese Government produced surpluses, the first since 2007-08.

Admittedly, the current Budget for 2024-25 is projected to record an underlying cash deficit equal to 1.0% of GDP, but that is quite a small turnaround equivalent to 1.3% of GDP. Also, although total government spending is forecast to increase significantly in 2025-25 by 4.5% in real terms, that comes after a couple of years of falls, and government payments are still less as a share of GDP than in the last two years of the Morrison Government.

Most importantly, Labor’s new spending has largely been directed to repairing the damage done to many government services ranging across health, education, aged and child care, foreign affairs and the public services by the Morrison Government’s deliberate attempt to save money by underfunding government responsibilities. Even now, it is arguable that more money is needed to restore adequate service delivery, but that would require extra revenue; something from which the Albanese Government has shied away.

Furthermore, without that extra government spending it is likely that the economy would already be in recession. The latest national accounts show that private consumption, which accounts for around 60% of aggregate demand, fell 0.2% in the last June quarter and, on a per capita basis, household consumption has declined for five of the last six quarters. Furthermore, household saving is now down to a very low 0.6% of income, much less than the peak of 24.1% reached during the COVID lockdowns, so it will be even harder to sustain household spending in future.

In addition, in response to the weak household demand, the volume of private business investment has also fallen in the last two quarters by 0.5% in the March quarter and 1.5% in the June quarter. In sum, without the increase in government spending, which contributed half a percentage point to GDP growth in the first half of 2024, the economy would be going backwards.

Similarly, over the four quarters ending in June 2024, the hours worked in the market sector fell by 0.7%, and the small increase of 0.5% in the total hours worked across the economy was entirely accounted for by the substantial increase in non-market sector jobs, further underlining that without the restoration of government services, Australia would be in recession.

Also, it should be noted that much of the additional government spending in this year’s budget is deliberately aimed at restraining the impact of inflation. The additional assistance for rents, electricity bills, cheaper medicines and childcare are all aimed at reducing the recorded rate of inflation as well as providing cost-of-living relief. For example, Treasury estimates that the energy bill relief and the additional rent assistance will directly reduce inflation by half a percentage point in 2024-25 and without adding to broader inflationary pressures.

Conclusion

Although inflation is not yet back in the RBA’s target range, it is coming down, while the economy is already tottering on the edge of a recession. Furthermore, there are inevitably lags before any change in monetary policy takes effect, and so we can expect inflation to keep falling.

Even the RBA does not seem to envisage that any further increase in interest rates will be necessary. Its fear is that so long as inflation remains too high, there is an increasing risk that expectations about future inflation will change, leading to a wage-price spiral as experienced in the 1970s.

But as Jerome Powell, the chairman of the US Federal Reserve has noted, inflationary expectations have not taken off in the US and the US is therefor starting to cut its interest rates. Much the same is true here in Australia. Labour market institutions have change enormously since the 1970s and early 1980s, and, just as in the US, Australian inflation expectations have remained anchored.

Thus, it is time to start cutting interest rates here as well. Indeed, financial markets have already started pricing in one interest rate cut by Christmas and a total of three by May. Any delay will increase the risk of recession without changing the inflation pathway much at all.

In sum, the RBA should start cutting interest rates this year and the sooner the better. However, it is understandable that the RBA might want to wait until its December Board meeting as the next National Accounts will be released just before that meeting allowing the Board to consider the latest data on the economy before changing course. But the balance of risks strongly suggest that the RBA should wait no longer than December to start bringing interest rates down.

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