Simplistic interest rate debate a waste of time

For the last 18 months, the post-pandemic surge in inflation has dominated discussion and analysis of the Australian economy and the institutional debate following the review of the Reserve Bank, and arguably cost the governor his job.

To hike or to hold has been the question leading up to every RBA board meeting on the first Tuesday every month.

Everyone has an answer but almost no one is stopping to ask why we have placed the burden of stopping inflation solely on the shoulders of the RBA.

It demonstrates a widespread misunderstanding of both inflation and the way the RBA uses monetary policy to respond to it.

Contrary to some sentiment, a little bit of inflation is a good thing, signifying competitive pressures and dynamism in the economy; high and sustained inflation, however, is simply theft because it erodes the purchasing power of consumers and discourages investment. Inflation should therefore be tackled swiftly and comprehensively lest it stay high and become entrenched.

At the heart of any episode of excessive inflation is a dislocation in the ‘‘iron triangle’’ of supply, demand, and price. When too much demand chases too little supply, prices rise.

But not all these dislocations are the same. In some instances, inflation is caused by a lift in demand without a corresponding supply response. In others, supply may be cut (say, by bad weather event or a pandemic) leaving demand to be unsatisfied at the current price level. While the outcome of these two instances – elevated price growth – is the same, the central bank’s primary policy tool (interest rate hikes) can only address the former by reducing aggregate demand in the economy.

We know from work by the RBA and the Treasury that the current bout of elevated inflation has been mostly due to supply shortages. That means that interest rate increases by the RBA over the past year or so have been mostly ineffective in addressing the main cause of inflation. Throw in the flip-flopping communication from the RBA – which has jumped between inflation hawkishness and growth bearishness – and there is little wonder we don’t understand what the next RBA decision on interest rates will be.

Everyone has an answer but almost no one is stopping to ask why we have placed the burden of stopping inflation solely on the shoulders of the RBA. Picture: NCA NewsWire / Nicholas Eagar

Unsurprisingly, with very few exceptions, economists – including us – have repeatedly been left red-faced when trying to predict the economic environment over the past couple of years.

There has been much disagreement in relation to whether or not the RBA board will lift interest rates at a given meeting – and in general. That suggests something more than just differing forecasts for inflation, unemployment, and economic growth.

The significance of the discord is both important and dangerous.

Why has this discord arisen? Dogma and orthodoxy have no doubt played a role.

Look no further than the frustrating debate about whether excessive profits are to blame for inflation in Australia.

Left-leaning economists and business groups at 20 paces makes for good headlines, but it is poor analysis.

What is the true extent to which excess profits are driving inflation? It doesn’t make for a sexy headline, but “it’s complicated” would be a reasonably accurate answer. Is there evidence of systemic price gouging and excessive profits across the Australian economy, such that it is a key source of inflation? No.

But are there examples of market power, weak competition, duopolies and oligopolies in key sectors that are probably contributing to poor productivity growth and higher prices for some goods and services? Absolutely. Anyone who has purchased goods or services from the banking, airline, supermarket, insurance or telecommunications sectors in Australia could tell you that.

In a simplistic debate about inflation and interest rates, the importance of economic reform can easily be lost, as it has been for more than a decade. Indeed, with structural change in our economy being driven by technology and climate change, we can expect a greater variability in inflation even at low levels of inflation. This is where the analysis and debate should turn to – not just the simplicity of a 2-3 per cent inflation target.

A more sophisticated debate about the nature of inflation – its variability and not just its level – will matter more because the world is becoming more complex, more volatile, and less certain. Correctly diagnosing economic issues and appropriately implementing policy prescriptions will only be more difficult in a world that is murkier.

What the recent debate on monetary policy revealed is that macroeconomics is still in its infancy.

Those with an ‘‘end of history’’ mindset about economic ideas and policy responses, and those who let dogma and orthodoxy bias their analysis, risk failing the primary test of any policymaker: first, do no harm.

Stephen Smith is a partner at Deloitte Access Economics. Dr Pradeep Philip is head of Deloitte Access Economics.