The debate over interest rates can sound more complicated than it really is. Strip it all back and the basic point is this: The Reserve Bank raises rates when it thinks inflation is staying too high for too long, because if that happens, fixing it later on can become harder and more damaging.
That’s probably cold comfort for Australians suffering from mortgage stress as their interest payments go up, but it is the lesser of two evils once we are stuck in a high inflation environment.
But there is also a risk in pushing too hard too soon to bring inflation back under control. Higher interest rates can slow the economy by making borrowing more expensive, also risking increased unemployment.
When the RBA decides to put rates up, it isn’t choosing between inflicting pain or not. It’s trying to judge how much pain is necessary now to avoid worse pain later on.
Simply put, managing interest rates is a balancing act, and if the RBA gets it wrong, it mismanages the situation.
The problem for RBA Governor Michele Bullock is that when she’s done the right thing, it’s hard to prove, because all the bad things that would have come had she not lifted rates early enough never end up happening.
Sometimes the challenge isn’t just whether the bank got the economics right; it’s also whether it had the institutional nerve to do what the inflation outlook required when the politics gets difficult.
The problem for RBA Governor Michele Bullock (pictured) is that when she’s done the right thing it’s hard to prove, says Peter van Onselen
Governments rarely welcome rate rises. Some, like the current mob, are quick to heap blame on the RBA. We’ve seen a conga line of backbenchers criticise the RBA in recent times for not bringing rates down quickly enough as inflation was slowly subsiding.
Yet once it became clear that inflation was still a problem – and that was before the Middle East conflict turned it into a crisis – where did all the RBA’s critics from within parliament go? They certainly haven’t lined up to admit their mistakes, that’s for sure.
Higher mortgage repayments are electorally poisonous, especially when households are already under pressure. We know that. Public pressure against tightening monetary policy (aka putting rates up) is therefore to be expected.
The point of an independent central bank is that it’s supposed to act anyway. Do what it needs to do, notwithstanding the political pressure to sit on its hands.
At the most basic level, the RBA put rates up to slow the economy down because inflation is too high.
Inflation often takes hold when demand in the economy is running too strongly relative to supply. If households are spending freely, and businesses are investing confidently, there can be too much money chasing too few goods and services. That pushes prices up, which equates to inflation. Lifting interest rates is how central banks try to cool that down. They don’t have many other levers at their disposal.
Governments can help, of course, by spending less, and therefore taking money out of the economy. As we know, however, government spending is currently at a record high, and it’s projected to go even higher in the coming years unless Labor gets on top of it. That’s stoking inflation before we even consider the impact of the war in the Middle East.
‘Governments rarely welcome rate rises. Some, like the current mob, are quick to heap blame on the RBA,’ writers Peter van Onselen (Pictured: Treasurer Jim Chalmers)
Higher interest rates make borrowing more expensive. Mortgage holders have to put more of their income into servicing their loan, and businesses face higher financing costs. People thinking about taking out loans become more cautious, both about their looming purchase on credit, but perhaps also about discretionary spending in their daily lives. Banks can also become reticent to lend.
Households with bigger repayments have less money left to spend elsewhere in the economy. Weaker spending helps to reduce pressure on prices, thus putting downward pressure on inflation, but it also risks slowing down the economy and, in extreme situations, causing a recession.
So when the RBA raises rates, it’s usually because it thinks inflation isn’t falling quickly enough, or there is a risk it could remain too high for too long unless demand weakens.
It’s effectively saying that doing nothing would risk inflation becoming a more permanent part of the economy, which is its own problem – more on that later.
None of this means the RBA wants people to suffer. It’s not a sadistic organisation that enjoys inflicting harm on average Australians. RBA governors don’t get a kick out of being painted in the media as the bad guys. Nor are they trying to cause a recession, although in extreme situations where inflation is stubbornly high, the RBA can be prepared to risk one.
Former PM Paul Keating once talked about the ‘recession we had to have’ in this country in the aftermath of interest rates hitting the high teens.
The preferred outcome for the RBA is always the same: bring inflation down while keeping the economy growing and unemployment as low as possible. That’s the so-called soft landing it aims for, but things don’t always pan out that way.
What are the risks of not doing enough?
The biggest risk is that inflation stops being just a short-term problem and starts becoming built into how people behave. That’s what economists mean when they talk about inflation becoming entrenched.
Political Editor Peter van Onselen explains why RBA rate rises now are the lesser of two evils
It’s not just that prices stay high for a while: businesses, workers and consumers begin to assume that higher inflation is normal and they adjust for it accordingly. Workers seek larger pay rises, because they expect living costs to keep rising. Businesses lift their prices not just because their costs have gone up, but because they expect future costs to keep rising. Contractors start building in larger price increases when doing deals. Inflation becomes part and parcel of the system.
That’s dangerous because once inflation starts feeding off itself, it usually takes a much stronger response to bring it back under control. What might have been dealt with through modest rate rises early on might require larger and more frequent increases later. After which people might be stuck with those higher rates for longer to get inflation back in check, before the RBA can bring rates back down again.
And this situation heightens the risk of a recession, which usually results in massive job losses. The more severe the tightening, the greater the chance of recession and higher unemployment.
There is another risk, too. A central bank that doesn’t act firmly enough while inflation is still clearly a problem, can leave itself with less room to move when a fresh shock arrives. For example, a pandemic or global financial crisis.
So while inflation is unpleasant, and raising rates in response to it makes people’s lives even more unpleasant, leaving inflation unchecked only delays pain, and when that pain eventually comes, it’s likely to be far more acute and enduring.
Is there a danger in doing too much too soon?
There absolutely are dangers attached to increasing (or cutting) rates too soon or by too much, but the weakening of our institutions makes that less likely than it used to be.
Those in charge, whether we are talking about the bureaucracy or politicians, aren’t the most courageous bunch these days. They therefore aren’t likely to charge into a challenge with the sort of fearlessness that can unwittingly shape action into foolhardiness.
The consequences of acting too slowly are therefore more likely than the consequences of acting too soon these days.
Nonetheless, interest rate rises can hit real people and businesses really hard. Which is why raising rates too fast, or too far, can be dangerous. If the RBA over-tightens it’s monetary policy settings, it can slow the economy more than was necessary. When that happens, growth stalls, unemployment rises and the risk of recession becomes very real.
Because rate rises don’t hit everyone evenly, anyone with large mortgages feels them much more quickly. Equally, small businesses carrying too much debt can quickly go to the wall.
And it’s worth remembering that a rate rise today doesn’t fully hit the wider economy tomorrow. It can take months for the full effects of it to wash through household budgets, business decisions and the labour market. That means the RBA is always making decisions with incomplete information. It tries to judge its timing and actions, but doesn’t always get it right.
The situation becomes even more complicated when the inflation problem is being worsened by supply shocks from abroad, rather than just excess demand or over spending at home.
A jump in global energy prices, for example, can lift inflation while also weakening economic growth. In that situation, rates still matter because central banks need to stop higher inflation becoming embedded within people’s expectations. But higher rates won’t directly produce more oil, obviously, or lower freight costs, and they can’t fix overseas disruptions.
The RBA is constantly weighing up the risk of inflation becoming entrenched against the risk of causing damage by putting rates up unnecessarily.
If the RBA does too little, inflation may become sticky and require a nastier correction later on. If it does too much, it can unwittingly help cause the downturn it was trying to avoid in the first place.
But hey, at least the head of the RBA always has an economics degree. That’s more than you can say about the Treasurer right now!