RBA faces rate-rise balancing act in bid to curb spending and avoid recession

The Reserve Bank of Australia offices in Melbourne.

If the world was sleep walking into recession … now we’re wide awake and running flat out towards it.

The commentary this week from US Federal Reserve Chair Jerome Powell, that he would prefer to risk recession rather than endure persistent high inflation, says everything.

For we know that wherever the Fed goes, the Reserve Bank inevitably follows – six to nine months later.

That puts the RBA raising interest rates this year and well into next year, to curb consumer spending behaviour and get on top of inflation. So far, though, with its key cash rate well below the rest of the world, it’s not going so well.

Higher prices have yet to stop Australian shoppers. Picture: NCA NewsWire/Andrew Henshaw

This week, retail sales in May were a record, for the fifth consecutive month. While there are price rises, it hasn’t stopped Australian shoppers. They have a head of steam up.

And jobs vacancy stats that show there are as many positions available as there are people who declare themselves unemployed says our labour market has no spare capacity.

These stats are the stuff of boom times, not the period of austerity the RBA is hoping to achieve. In hindsight, you might now wonder why the Reserve Bank and successive governments were so determined to achieve an unemployment rate with a 3 in front of it, by keeping interest rates so low for so long.

Why was full employment not deemed as something with a four in front of it, so there was some spare capacity and so wages might not break out.

The lesson from the US is clearly there … where labour shortages created a wages spike – which along with energy prices caused inflation to become embedded.

The broad consensus is that although Australia’s growth slows down sharply next year, under the weight of higher interest rates and wages, the nation will avoid recession – unlike the US and UK. This is largely based on a presumption about the export of minerals, grain and energy.

But this also presumes the RBA makes the right moves at the right time, thus avoiding a credit shock and rising bad debts sparked by falling home values. At the edges, it is inevitable there will be household casualties as interest rates rise.

Note that late this week, as more economists forecast big home price falls, Deutsche Bank chief economist Phil O’Donaghoe said house prices would fall 15 per cent in the next 12 months – the biggest fall in 50 years. A big drop in home prices alone will stop spending in its tracks.

So what will the RBA do? It will raise interest rates next week, and most likely in a month’s time. But as I have said before, it is not the first interest rate rise, or the second, that does most economic damage. It is always the last one.

Because even before we have entered the worst of the economic furnace, the Commonwealth Bank is already saying that interest rates may have to be cut late next year. But that will only be true if the Reserve Bank thinks the inflation genie has been well and truly bottled.

For the best guide, always turn to the markets. Though fickle, the long-term yield on 10-year and three-year bond rates have come noticeably off their peaks in the past two weeks. The 10-year rate peaked above 4.1 per cent in mid-June; now it is just above 3.5 per cent.

The bigger question, to be weighed up by government, business, investors and homeowners is how much damage the inflation-crushing central banks are prepared to inflict – how high they are prepared to raise rates – before they consider the job is done.

Ross Greenwood is Sky News Business Editor