Why the RBA’s rate hike isn’t working

The Reserve Bank of Australia’s decision this week to raise official interest rates by half a percentage point surprised many. The bank is a notoriously conservative organization. It usually likes to take it slow. Since it suggested last year that it was unlikely to do anything drastic about interest rates until wages started to rise sharply, its decision to raise rates by half a point when real wages fall was not very conservative. Things change quickly.

While we talk a lot about interest rates in Australia, we don’t talk much about what they are supposed to do to the economy. Economists call the link between interest rates and inflation the transmission mechanism of monetary policy, but in reality it’s a long list of “maybes.”

Everyone knows that if we raise interest rates, people with a variable home loan will have to spend more on their repayments and in turn spend less on other things. But given that only about a third of people have mortgages, and many of them have fixed-rate mortgages, most Australians are unaffected by this link in the transmission mechanism. Fortunately for the Reserve Bank, a third of Australians still own their homes completely and higher interest rates mean house prices will fall, which the RBA believes will make them feel less wealthy and consequently less likely to spend money. Then there are companies whose banks assume they will invest in less new equipment at higher interest rates. Again, that may be a lot, although there is some evidence that each of those effects will eventually show up a little.

Precision aside, it’s a safe bet that when interest rates rise, some people and some businesses will buy less stuff and as a result, some businesses will stop raising their prices. The result is lower inflation – unless something unexpected happens. It was, of course, unexpected things, not rampant consumer spending, that caused this latest rise in inflation.

For decades Australians, and the RBA, have been trained to focus on one form of price pressure known as demand-driven inflation. Fluctuations in demand drive prices up – think shrimp, hotel rooms and flights at Christmas time – but when unemployment is low, wages are high and companies invest heavily, all that spending drives up the price of everything. Companies use higher prices to ration the things they sell when they are in short supply. When a lot of prices start to rise, the RBA slows down by making all of us spend more money on interest payments and less on the things we want to buy.

But Australia’s current spurt of inflation is not being driven by rising consumer demand or rising business investment; it is caused by global increases in energy prices and a wide variety of consumer goods. Economists call this cost inflation and, more importantly, braking Australian interest rates won’t do much to lower our inflation when there is a global freight train propelling it.

Some commentators have criticized the RBA for not starting to raise interest rates earlier this year, arguing that we should have tried to nip inflation in the bud. But while interest rate policy can be effective against demand inflation, it is impotent against the form of cost inflation that is currently driving up the cost of living in Australia. While policymakers like to ‘do something’ in a crisis, the reality is that Australia is in a unique situation and the old scripts of economic management don’t fit well with the new economic reality, or even the thinking of the new government.

Fortunately, there is an imminent review of the role of the RBA. While that won’t help push the price of oil or lettuce, hopefully it will help Australia develop a more sophisticated approach to responding to a variety of problems such as energy price shocks, chronically low wage growth and the cost of housing in this country. In the meantime, the question is what the RBA is likely to do and what it should do in the coming years.

In the short term, it is almost inevitable that the RBA will continue to raise interest rates and as a result, mortgage payments for a third of Australians will continue to rise, house prices will level off or fall, and many businesses will face higher borrowing costs and less money are likely to pause their expansion plans.

None of this will stop the war in Ukraine or accelerate silicon chip production in China, but it will curb the enthusiasm for profitable price increases from the oligopolies that dominate the Australian economy. Which brings me back to the next review. Energy and silicon chips aren’t the only things driving prices up in Australia. The growing profit margins of Australian companies also play a major role. Ten years of low wage growth have, unsurprisingly, led to 10 years of steady increases in the share of GDP going to profits.

While our media is full of stories of companies having “no choice” but to raise their prices, our national accounts are full of evidence that there has never been a better time to be an Australian capitalist. That’s not to say some businesses aren’t struggling, but it’s time Australia stopped pretending that because their local pub owner is struggling to find staff, Harvey Norman or the Commonwealth Bank need our condolences.

Much of our current debate on inflation revolves around the danger of a wage-price spiral, but how could that be a risk now that real wages are falling faster than ever before?

Australia is in the grip of an earnings-price spiral, with companies using higher prices for some of their inputs to cover up large increases in their profit margins. Yes, grain prices have risen, but grain accounts for an insignificant percentage of the retail price of a loaf of bread and wages are a minority of the cost to most Australian businesses.

One thing the upcoming investigation into the RBA should consider is who sits on the bank’s board. While it was once self-evident that the Australian Council of Trade Unions would be represented, today only business leaders and civil servants get a vote. Given historically low wage growth and the role of profits in driving inflation, it is clearly time for this to change. But while true diversity of opinion is good for the governance of any organization, the review of the RBA also needs to look further afield.

The Reserve Bank Act 1959 instructs the bank’s board to conduct monetary policy “for the greatest benefit of the people of Australia”. More specifically, it mandates them to pursue “the maintenance of full employment”. The law makes no specific mention of inflation. Despite this clear legal obligation, the bank has chosen for decades to prioritize inflation control over the goal of full employment. To be clear, the RBA believes that if it keeps inflation in check, unemployment will resolve itself. It’s like someone who promised to cook and said they thought cleaning the bathroom was a good start.

If the RBA does not want to be responsible for providing full employment, then the target must be removed from its law. If she wants to take her responsibility, she must make clear what that means for employment and unemployment. Likewise, any review of the RBA must look at the broader limits of the effectiveness of monetary policy in a society as unequal as Australia’s. Regardless of the goals of the RBA, when young families have million-dollar mortgages and our richest retirees have tens of millions in retirement, small changes in interest rates have huge implications for the distribution of pain and gain in Australia.

While the RBA can’t do anything to lower the price of energy or the profit margin of our largest retailers, there’s a lot a bank assessment can do to clarify who is responsible for what in Australia. For decades we have used laws to limit union power and workers’ rights to control imaginary wage-price spirals. At the same time, our leaders have been pleased with the reliance on competition among oligopolists to control prices and increase profits. The union laws have clearly worked, but competition policy has not.

Likewise, the generous tax treatment of real estate has for decades made the cost of housing higher than in almost any other country. As a result, the use of interest rate policy has become a blunt and unjust instrument. It is time we look at the whole problem instead of dealing with fiscal and monetary policy separately.

Inflation is not the biggest problem a country can face, but turning high inflation into big cuts in real wages is. Inflation in Australia is not driven by wage growth; it leads to cuts in real wages, which is why it is time for a major rethink of the role of monetary policy. A review of the role of the RBA has the potential to significantly improve Australians’ lives and the health of our economy, but as soon as it comes, it won’t do anything to make this winter more affordable.

This article was first published in the print edition of The Saturday Paper on June 11, 2022 as “Making bank”.

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