This week, the Reserve Bank will convene to determine whether to raise, decrease, or sustain interest rates.
Market predictions indicate an upcoming increase.
Considering the escalating fuel prices linked to the ongoing conflict in the Middle East, will the Reserve Bank apply additional strain on mortgage borrowers? If they decide to, what would the rationale be?
Should the monetary policy committee of the Reserve Bank take the data into account, it will not increase rates. Nevertheless, this does not eliminate the ongoing pressure on the central bank to address inflation concerns.
Inflation was already rising prior to the US and Israel’s actions against Iran. This uptick was due to temporary factors such as travel and accommodation costs.
In many respects, the rising prices of oil and gas are already achieving the same effect as a rate increase—limiting the spending capabilities of Australians. Additionally, since most of our fuel is imported, the resulting funds and profits are directed overseas. This decline in demand will serve to mitigate inflation that was present before the invasion.
In a sense, soaring fuel costs relieve the Reserve Bank from the need to raise rates in their upcoming meeting.
However, some individuals contend that the escalating prices of oil and gas will permeate into the broader economy, driving up costs and inflation… and despite the added burden on households, the Reserve Bank should raise rates as a precaution against even greater inflation.
Are they correct?
No, because this type of inflation is unaffected by interest rates.
The surge in oil and gas prices is a supply shock. This is a singular price increase triggered by an isolated event—war—and the generally accepted response to supply shocks is to refrain from action and observe as they influence the economy.
In this case, it is unnecessary to increase interest rates since inflation will largely self-correct.
Skeptical? Here is former RBA governor Philip Lowe articulating this point:
Regarding monetary policy and supply shocks, very little can be done by monetary policy to mitigate the effects of supply disruptions. Occasionally, you may wish to react to the heightened inflation stemming from a supply shock to prevent inflation expectations from escalating and becoming entrenched. However, if that doesn’t occur, you can allow the supply disruptions to work through the economy.
Raising interest rates serves to influence demand. When everyone faces higher mortgage payments, they have reduced disposable income for other purchases. A drop in demand means that businesses are less able to raise their prices.
Conversely, a supply shock affects supply, not demand.
Gas prices are increasing due to diminished supply from the Middle East. How could raising interest rates possibly lower gas prices? They cannot.
However, you may have noticed Philip Lowe's caveat:
“Occasionally, you may wish to respond to the heightened inflation stemming from a supply shock to prevent inflation expectations from rising and becoming entrenched. ”
This serves as a loophole for the RBA. It cannot rationalize elevating interest rates to address the supply issue. Thus, it rationalizes a rise in rates by claiming it is addressing inflation expectations.
When employees anticipate that inflation will surge in the future, they will seek higher salaries immediately. Otherwise, they will struggle to afford goods later on. If they receive those elevated wages, companies will raise their prices to account for the increased production costs due to higher wages. Consequently, irrespective of earlier circumstances, beliefs regarding heightened inflation lead to actual inflation increases. This creates a harmful cycle.
Currently, however, employees are having difficulty securing wage increases. Research from the Australia Institute indicates that wages are not pushing inflation. Furthermore, given the power dynamics between workers and employers, they are unlikely to win significant wage increases anytime soon.
Nevertheless, these inflation expectations provide the RBA with a convenient excuse. It can raise rates without being accused of misunderstanding economic principles. Instead, they will claim that this demonstrates the Reserve Bank’s commitment to reducing inflation, leading people to appreciate this resolve and anticipate lower inflation in the future.
In truth, the RBA has just one method for tackling inflation – increasing interest rates.
It is viewed as the singular entity tasked with combating inflation. When inflation rises, no matter the cause, the public expects the central bank to take action.
By "the public," I refer to the financial markets, and by "the markets," I mean wealthy individuals.
Thus, the RBA faces pressure to raise interest rates, even if elevated rates may have minimal effect on inflation driven by rising oil and gas costs.
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