The RBA has three options on Tuesday, but none are easy

The Reserve Bank could be forced to increase interest rates to stop the wages spiral, knowing this will have a devastating impact on the housing market. Picture: Joel Carrett

Mark down Tuesday, June 7, as one of the most important days in Australia’s recent history.

The Reserve Bank board will meet to decide whether to send the Australian economy into a steep decline led by the housing market, or take a punt and risk the dangers of spiralling inflation. If that punt fails we risk draconian measures.

This vital meeting is too important to debate at this time the RBA’s mistakes that contributed to the economy being over stimulated. The biggest issue now is RBA independence.

Before making its policy decision the RBA board will receive a mountain of statistics that can be summarised this way:

Australia has an agreed inflation rate of 5.1 per cent although in the December quarter it rose at annual rate of eight per cent.

The biggest single boosters to that inflation rate are what we might term supply-side forces – big price rises in oil, gas, power, food and imported goods. Those price rises have often been compounded by shortages of supply. No interest rate action by the Reserve Bank can alter these prices because they are a part of part of a world situation which has been made worse by the repercussions of the Ukraine war on energy and food prices.

The US Federal Reserve originally described these forces as transitory but, instead of fading they have increased in intensity. Worse still in America they have boosted wage rates so increasing conventional inflation which can be reduced by higher interest rates.

Currently the US share market rises on any sign of an economic slowdown and, as we saw at the weekend, the market falls when the economy looks like accelerating because that means US interest rates must rise further to attack the problem.

In Australia, the supply inflation has so far been basically insulated from wage rates. But the election changed the game and our economy now looks set for a wage explosion on the back of a substantial minimum pay rise and labour shortages created by overstimulation, lower immigration and Australians spending more money locally. The wage/price outlook is like a dry forest requiring only a small spark to create a raging inflationary bushfire.

The new government came to this dry forest with a battery of flame throwers in the form of big increases in public spending and a vow that wages needed to rise to match the cost of living pressures. True to their word they have advocated a 5.1 per cent rise in the minimum wage in the current Fair Work hearing.

Given the shortages of labour the inflationary fire will spread rapidly across the country.

Australia now faces a dangerous combination of conventional, wage-driven and supply inflation. Migration and local training can help relieve labour shortages but both take time.

So unless the statistics are rigged to suit a Martin Place or Canberra agenda, the above will be the facts put before the central bank.

The RBA has heard from the major housing lender, the Commonwealth Bank, that any increase in interest rates above the 1.25-1.5 per cent level will have a devastating impact on the economy because, in the boom, the banks (inexcusably) loaned $650bn or 30 per cent of the housing loan stock mostly to high risk borrowers.

Push rates higher than the CBA limit and not only will dwelling prices fall sharply but spending will be slashed and the economy will go into a steep downturn.

But the bond market is looking for a three per cent rise. And remember a three per cent interest rate increase will not stop supply inflation but it will limit the spread of any 5.1 per cent minimum wage rise. No other country in the developed world foolishly hosed unlimited money at their housing market via token but flexible interest rates. .

So let’s put on the table the unpalatable choices facing the RBA.

First, it can decide adopt the CBA approach and limit interest rate increases to, say 1.5 per cent and punt that the overseas supply forces will abate. If they don’t then the five per cent wage rise will send our inflation skyrocketing. At least twice in the last half century the central bank of the day, pressed by the politicians, took the low interest rate punt but lost. Inflation kept rising and required interest rates of between 10 and 17 per cent to prevent Australia going in the same path as Argentina. Dwelling prices in some areas fell 50 per cent. I will never forget 1990. In 1989, I bought a negatively geared rental property to keep my parents’ view and watched it fall at least 33 per cent as the interest rate I was paying rose to 17 per cent. I was able to hang on and the investment was ultimately lucrative. Most of the RBA directors and those in government were youngsters in 1990 and so do not have 17 per cent rates seared on their brain. The government will urge option one.

The second choice is for the RBA to go hard and early with higher rates and try and frighten the nation into wage restraint in the hope that the fear of more rises will do the trick.

If that fails then the third alternative emerges and the RBA raises interest rates to what ever level is required to force prices down and stop the wage spiral, knowing this will have a devastating impact on the housing market. But the rate rises will be much less than those required if option one is taken and it creates an inflationary bushfire.

Of course we are not in isolation. Australia can’t have interest rates markedly below the US for an extended or it will hit the dollar – further increasing inflation. And of course if oil, energy and food prices fall and the China supply chain is restored that will reduce the pressure.

None of the three choices is easy.

I might add that our democracy was not helped in the election campaign when neither party addressed the basic problems facing the Australian economy. Yet, both parties knew the issues. By not discussing reality they have left the Reserve Bank with no widespread community understanding of the state the nation. Both parties have a lot to answer for ends