Australia may choose recession to tame inflation

The governor of the Reserve Bank of Australia has started to talk about a narrowing path for the economy, and the need for a more potent tonic to cool inflation.

It is looking more likely that the answer to Australia’s stubborn inflation woes will be the onset of a recession.

It’s a desperate idea, but crashing the economy into a wall to escape the even greater threat posed by the wrecking ball of sustained high inflation is a possibility.

It might be the recession Australia has to have.

The governor of the Reserve Bank, Philip Lowe, has started to talk about a narrowing path for the economy, and the need for a more potent tonic to cool ­inflation.

The RBA board raised interest rates further last week and warned that upside risks to inflation are increasing. The admission surprised many, given that the central bank has delivered 400 basis points of policy tightening in a little over a year.

“It is too early to declare victory in the battle against inflation,” Lowe said.

The comments forced economists to raise their forecasts for the peak in the official cash rate. Goldman Sachs now expects rates to rise as high as 4.85 per cent, putting them on par with rates in other major economies.

The RBA has been working towards steadily bringing inflation down over the period to mid-2025, a trajectory that has assumed a modest peak for interest rates and the preservation of historically low unemployment.

Lowe’s patience with stubborn inflation is now clearly wearing thin, and the path ahead for the economy looks more like an overgrown track leading to a darkened forest.

The prospects of a hard landing for the economy, where unemployment rises quickly and many vulnerable small businesses are swept away, are increasing.

“I want to make it clear that the desire to preserve the gains in the labour market does not mean that the board will tolerate higher inflation persisting,” Lowe said in his midweek speech.

A number of things are changing. Australia was supposed to be different from the rest of the world. It was thought that to tame inflation, interest rates wouldn’t have to be raised as far as those in other major economies.

That assumption is rooted in the idea that the systems that determine wage increases are slow-acting in Australia, while there is also a high exposure to variable mortgage rates, which means interest rate increases manifest quickly for those paying back home loans.

So far, that has played out. Australia’s official cash now stands at 4.1 per cent, which compares with New Zealand’s 5.5 per cent, Canada’s 4.75 per cent and the US at 5 to 5.25 per cent.

But wage pressures are building after Australia’s minimum wage was lifted by 5.75 per cent last week, and state governments have also taken steps recently to lay the stage for bigger pay rises.

The RBA fears that price expectations could become unhinged at a time when inflation remains sticky, running at close to 7 per cent, with service prices proving extremely hard to cool.

Inflation hasn’t fallen as the RBA had hoped, and risks to the upside are growing. The central bank looks to be a lot closer to giving in on pursuing a soft landing for the economy.

The economy grew by just 0.2 per cent sequentially in the first quarter, leaving it perilously close to a contraction. It won’t take much to kick away what remains of its supports.

There are also forces acting on the economy that are beyond Lowe’s control such as weak productivity growth, high global inflation, wage increases, surging rents and a massive jump in migration, which is running at close to twice the normal rate.

Yet he is being called on to deal with it armed only with interest rates.

Perhaps the idea that Australia could tackle such a big inflation problem while avoiding recession was unrealistic, but it will be definitely be put the test in the next quarters.

The Wall Street Journal