Interest rates have risen again, which could send the housing market reeling and even jeopardize the economy as the RBA battles high inflation. But the rate hike cycle is far from over.
Official interest rates rose half a percentage point to 1.85% on Tuesday as the RBA board met in Sydney to find a way to stamp out rapid widespread rate hikes.
“Raising interest rates in recent months has been necessary to bring inflation back towards target and create a more sustainable demand-supply balance in the Australian economy,” the RBA governor said in a statement.
“That [RBA] Board is committed to doing whatever is necessary to ensure that inflation in Australia returns to target over time.”
Interest rates have risen extremely fast, from 0.1% at the start of the year to 1.85% on Tuesday and are almost certainly not peaking yet. They could go much higher if some predictions are to be believed.
What predictions should we watch out for? Talk is cheap, but some people put their money where their mouths are, in interest rate futures markets. These markets are predicting rates will rise to a peak of just over 3% in March 2023. That sounds like a lot more rate hikes, but as the next chart shows, forecasts from not too long ago called for even more aggressive rate hikes. Recently, expectations have become more subdued and even point to falling interest rates in the second half of 2023.
Inflation: The old enemy
Fighting inflation was one of the great successes of economic policy in the last 30 years. Now, with fuel prices over $2 a liter and $9 in lettuce, that victory is in jeopardy.
The word inflation refers to sustained, widespread increases in prices. High inflation is considered bad, not least because it erodes the purchasing power of savings. If you had $1,000 in the bank a year ago, you’re buying about 6% less now thanks to our 6% inflation last year. Inflation hurts everyone with money saved, like retirees (although it does help everyone with debt, because the real value of the debt goes down).
But the reason we fear inflation goes deeper. When inflation kicks in, it changes inflation expectations. Everyone who negotiates for wages is asking for a large percentage increase every year and these higher costs translate into higher prices and we can get stuck in an inflationary spiral. No one gets better off, but prices keep going up. Then the only way to bring inflation back down is to really weaken the economy. The RBA’s hope is to bring inflation back under control before inflation expectations become persistent and without sending the economy into recession, a challenge the governor has described as a “narrow path”.
Runaway price increases
The RBA’s job is to control inflation. It fails, as the next graphic shows. Inflation has shot well above the 2% to 3% target range.
Why does inflation happen?
A company will raise prices when it has more customers than it can support. Think of a trader whose phone is out of control. Suddenly he adds 10% (or more!) to all his offers.
When many companies are in this situation, they all raise prices and we get widespread inflation. Then the RBA steps in and hikes rates. This has three main effects, all aimed at reducing the need for companies to raise prices:
- Households have less money to spend because people have to put more money into their mortgages.
- Businesses spend less because the cost of borrowing is higher.
- The “wealth effect”: When interest rates rise, house prices fall, people feel less wealthy and spend less.
You’ll find one thing in common: Aussies feel poorer so they spend less. Yes, fighting inflation is painful, so let’s keep it under control first.
There are a few other monetary policy options that also involve generating less spending from Australian companies.
- People save more when interest rates are higher. When they save more, they spend less.
- When interest rates are higher, the exchange rate rises, making imports cheaper and domestic goods more expensive in comparison. (It works in theory, but right now most central banks are raising rates. And some are rising much faster than Australia, so our rate hikes are probably just preventing our dollar from weakening, not actually making it stronger.)
- When home prices fall, fewer homes change hands, and we spend less on real estate agents and transportation companies, movers, and furniture (when people move, they usually buy new things.)
All six reduce the amount of money Australians spend on domestic businesses. That’s no fun for anyone — it feels cramped for homes and businesses alike.
Will it work? It will if the problem is as described above: that they “have more customers than they can support”.
But of course a lot of inflation right now is about import prices. Putin’s war has rocked global wheat and oil markets, and prices are sky-high. For example, crushing Australian household budgets under huge mortgage repayments won’t move the scale of petrol prices much. So there’s reason to be skeptical about the RBA’s ability to smack down inflation really quickly, even if it hikes rates as quickly as forecast.
The “narrow path” the RBA is on might be more of a tightrope walk.
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