Next Steps for the Australian Economy
Examining RBA options moving forward
J. A. McCreery
*Written 29/8 and does not contain data from most recent RBA release
As the Australian economy seeks to recover from recent economic strains, there is a distinct need for future interest rate rises and the repeal of unconventional monetary policy. Both domestic and global inflation are on the rise and as such an upwards movement of the OCR is necessary to reduce inflationary pressures and stabilise the Australian economy. Further, the unprecedented use of unconventional monetary policy requires ‘normalisation’ to again bring stability to the economy and avoid the pitfalls prevalent with its continuation.
Headline rates of inflation hold at 6.1%, having been buoyed by COVID-related supply disruptions, socio-economic crisis (Ukraine) and strong demand which is putting pressure on productive capacity. While this inflation level is still below the 8.5% in the USA and the circa 7% rates in Europe, the UK, Canada and NZ, the Australian economy’s high rates of dependency on commodity exchange and foregin trade indicates that inflation is likely to rise in tandem if left unchecked. Coles, for example, has warned of further significant supermarket inflation throughout 2023.
The need for future interest rate rises is supported by Dr Oliver who asserts that a rise to “over 2% mid next year” will be required to cool inflation. Note, the magnitude of such rate hikes is amplified by Australia’s high level of household debt and as such will not be required to reach rates such as those seen on the international scene. The need for immediate cash rate hikes is present nevertheless, reinforced by the experience from the late 1970s oil shock, which made evident that the longer inflation persists the more inflationary expectations rise, in turn, making it difficult to control inflation without falling into recession.
Economic growth is unlikely to be threatened by policy interest rate rises due to the resilience of Australian markets, again reifying the efficacy of such raises. The tightening and strong job market is expected to continue supporting households alongside the mass financial buffer of $250bn accrued throughout the pandemic. Previous rate tightening cycles in 1994, 1999 – 2000, 2002 – 2008 and 2009 – 2010 were all able to avoid recession whilst reducing inflation thus highlighting the effectiveness of such a campaign.
Although rate rises will place pressure on indebted Australian households, cutting into their spending power, it will be manageable for most borrowers. 40% of variable rate borrowers would see no increase in monthly payments from a 2% mortgage rise as they have already been paying in excess. The RBA also asserts that “the majority of households will be well placed to manage higher … loan payments”.
Another important consideration is the impact of raising the Official Cash Rate (OCR) on the share market. Whilst higher rates place pressure on share market valuations, early in the economic recovery cycle this impact is offset by improving earning growth. Rising interest rates are only detrimental when rates reach onerous levels (i.e. above ‘normal’) contributing to economic downturn, e.g. in 1981-early 1982 or late 2007 to early 2008; there are also problems when rate hikes are aggressive, as in 1994 when the cash rate increased from 4.75% to 7.5% in four months and placed excessive downwards pressure on the economy (Dr. Oliver).
Such evidence, accentuated by the highly indebted nature of the Australian public, makes clear how, although rate hikes are necessary, they must be moderate and be made under highly informed conditions.
The withdrawal of unconventional monetary policy is another decision which the RBA must consider in order to safeguard the stability and longevity of the Australian economy. Unconventional monetary policy comes in four terms: (1) negative interest rates, (2) extended liquidity operations, (3) quantitative easing and (4) forward guidance. All can be effective in theoretical vacuums but are unnecessarily arduous on policy makers, leaving room for error in their execution.
In recent years the RBA has been largely involved in quantitative easing and forward guidance as means of relieving strain from the pandemic economy. Quantitative easing or asset purchasing involves the outright purchasing of assets by the RBA in the private sector through the creation of ‘central bank reserves’. The main goal of such purchases is to lower interest rates on risk-free assets through a range of maturities which works to lower a range of interest rates, this can be especially useful in instances where the OCR is as low as it can practically go i.e. at its effective lower bound. Forward guidance relates to the communication of the RBAs stance of monetary policy and is used to reinforce central banks commitment to low interest rates, thus reducing uncertainty about economic and financial outlooks, in turn promoting consumer confidence.
The willingness of central banks to supply liquidity in times of economic strain may reduce the incentive of banks to hold adequate financial buffers, which could make episodes of financial stress more likely. Persistently low interest rates can also fuel asset price growth (e.g. increasing in price of real estate and shares) despite weak economic conditions, so that growth in debt can become unsustainable and increase the risk of financial instability. Under unconventional policy, the role of monetary and fiscal policy can also become blurred, because if the central bank is purchasing large amounts of government securities (i.e. government debt) at 0% interest, this could be interpreted as government spending that is financed by money creation. This misinterpretation of QE, in turn, can create a host of public distrust and political tension due to the misconception it involves ‘printing money’.
Furthermore, in the uncertain world of economics, failings in forward guidance are almost inevitable as circumstances are always changing, yet egregious failures in future warnings, e.g. Philip Lowe claiming Australian interest rates will not rise till 2024 when they are rising quickly in 2022, harms the reputability of the RBA and in turn consumer confidence and economic stability.
There is an undeniable need for interest rate rises in the current Australian economy which, combined with ‘normalisation’ of monetary policy, will ensure the easing of inflationary pressure and the economic wellbeing of the financial system.