Interest rate decision is not simple for RBA to make

It is an unfortunate fact that in the heat of a federal election campaign, the clamour for the Reserve Bank of Australia to act quickly to lift interest rates to combat inflation has become something of a blood sport. There is no shortage of opinion about how not acting now would risk the RBA’s credibility and perception of independence. It is undoubtedly true that with the cash rate at emergency levels of 0.1 per cent, the RBA will have to act at some stage to bring things back to more normal levels. It is also true the global economy continues to face uncertain times, with the war in Ukraine spreading risk throughout Europe and beyond, and forcing higher energy prices that cascade through global markets.

There is one view that, faced with headwinds of uncertainty, hitting the economic brakes too early might derail recovery from the pandemic and only compound problems down the track. The more orthodox view is that the RBA must follow the numbers today and lean in to avoid runaway inflation that will be more difficult to tame, a painful situation that Australia experienced in the 1970s.

As things stand today, the RBA has moderated its language of late last year and no longer is saying it will maintain the emergency cash rate of 0.1 per cent until 2024. It is possible that rates will increase as early as next month based on the March quarter consumer price index figures released by the Australian Bureau of Statistics on Wednesday. These showed the CPI rose 2.1 per cent in the three-month period and 5.1 per cent across the 12 months to March. The most significant price rises were new dwelling purchases by owner-occupiers, up 5.7 per cent, and automotive fuel, up 11 per cent. Trimmed mean annual inflation, which excludes large price rises and falls, increased to 3.7 per cent – the highest since March 2009.

Significantly, non-discretionary annual inflation was higher than the CPI and more than twice the rate of discretionary inflation. Non-discretionary inflation includes goods and services that households are less likely to reduce their consumption of, such as food, automotive fuel, housing and health costs. In the March quarter non-discretionary inflation grew by 3 per cent.

The questions that must be asked are: Is the March quarter rate of inflation outside the parameters set by the RBA when it said it would be patient on lifting rates? And would higher interest rates have the desired impact of curbing inflation that is driven by non-discretionary spending and global events?

The paradox is that the RBA has been calling for above-CPI wage increases to stimulate inflation but, given the high level of imported inflation, a wages breakout is exactly what may entrench inflation and make it more difficult to tame. The RBA has been criticised by some for not acting sooner and history may well judge this to be the case. But the evidence to date is the RBA board has been prepared to change its position but keep its eye to the distant horizon rather than the excitement of markets and commentators.

In October the board remained committed to not increasing the cash rate until actual inflation was in the 2 to 3 per cent target range. It said: “The central scenario for the economy is that this condition will not be met before 2024.” This was changed in November when the board dropped the reference to 2024 but said it “was prepared to be patient”. In February the board said while inflation had picked up, members agreed it was too early to conclude that it was sustainably within the target band. There were uncertainties about how persistent the pick-up in inflation would be as supply-side problems were resolved. Again, the board said it was prepared to be patient. Last month the RBA noted that inflation had picked up more quickly than expected but remained lower than in many other countries. The central forecast was for underlying inflation to increase further in coming quarters to about 3.75 per cent before declining to about 2.75 per cent over 2023 as the supply-side problems were resolved and consumption patterns normalised. “The CPI inflation rate will spike higher than this due to the higher petrol prices resulting from global developments,” the RBA said. “How long it takes to resolve the disruptions to supply chains is an important source of uncertainty regarding the inflation outlook, as are developments in global energy markets.”

This month the RBA anticipated that measures of underlying inflation in the March quarter were expected to be above 3 per cent, bringing forward the likely timing of the first increase in interest rates. With the March quarter spike confirmed, the next step will be publication of an updated set of bank forecasts next month.

The RBA has a difficult decision to make but one that must be free of political considerations. Uncertainty remains about the global outlook and how long it will take for post-pandemic supply-chain issues to be resolved. Higher rates will have little impact on global oil prices or building costs forced higher by supply constraints. Many of our inflationary problems are driven by a squeeze on supply rather than an excess of demand. This is not possible for the RBA alone to solve. Whoever wins government must focus on boosting productivity, freeing up labour and unblocking the bottlenecks on the supply of materials. There is still a case to tread warily. Economic momentum is an invaluable commodity in uncertain times.