“A policy that targets the young and the poor to solve an economy wide problem is neither equitable nor long-term efficient“
John Mangan
Introduction
The Reserve bank of Australia has a target range for consumer price inflation of between 2-3%. This target level is shared by many central banks including the US Federal Reserve , to achieve these inflation targets Central banks primarily use monetary policy, particularly interest rate policy. This creates two connected macro- economic issues. What is the optimum inflation rate target and is interest rate policy the best means to obtain this target In common with most economic issues there are disagreements over what constitutes an optimum inflation rate1 but most research shows low (but not zero) levels of inflation provide best benefit in terms of consumer welfare2, However. There is increasing doubts over whether interest manipulation is the best means to achieve the desired inflation targets.3
Nominal versus real interest rates
Nominal interest rates are those generally quoted to borrowers and describe the numeric value of the interest rate. At times of zero inflation nominal interest is equal to real interest but as prices rise through inflation the two interest rates differ. The real interest rate is the nominal interest rate adjusted for inflation. Shifts in real interest rates mirror changes in the purchasing power of money. When inflation is high, real interest rates are significantly lower than nominal interest rates, thereby reducing returns on investments. In response, Central banks often raise nominal interest rates to restore balance. But this response if taken too far creates its own problems.
Why use interest rates to control inflation
When central banks raise interest rates, it becomes more expensive to borrow money. This is done by setting the short- term borrowing rate for commercial banks which influences interest rates on loans and borrowings throughout the economy and slows down consumer and producer spending. It is a standard technique employed since the 1970s across the world; a simpler time in which the economies were more predictable. Since then, most economies have become more complex (heterogeneous) and much less domestically orientated. Therefore, this standard policy approach is both relatively slow process and is predicated on the assumption that the inflationary pressure is being driven by demand pressure (excess demand) throughout the economy. It is less effective against cost-based inflation, such as wage growth above productivity or cost increases driven by supply shortages and/or or by institutional factors where firms use their market power to raise prices arbitrarily.
Contemporary inflation in Australia
Price inflation in Australia began to exceed the Reserve band target band in mid-2021 and (to this point) has peaked in early 2023
Figure 1 Price Inflation in Australia Jul 2020- July 2023
In response the reserve bank raised nominal interest rates 14 times over this period to a cash rate level of 4.10% which represented an increase of 4 percentage points since May 2022. The months of July and August 2023 has seen rates rise paused. In response to these successive interest rate rises the inflation rate has moved to 6%. Still well above the target rate.
Problems with the current policy
- There are significant problems with the current policy
- It is slow to impact on price inflation
It is predicated on a policy response which does not recognise adequately the segmented nature of the contemporary Australian economy
- It is a sledgehammer weapon that fails to recognise the real causes of the contemporary inflation
- As a result, it targets the wrong groups in Australia and disproportionately targets the young and the poor
Is excess demand the main problem and who is driving it?
The RBA is correct to point to areas of high discretionary spending in Australia over the recent period which have proven resistant to these interest rate changes and under the limited policy options open to the RBA have led to successive interest rate increases For, example, the Commonwealth Bank IO report of May 2023 found travel and accommodation spending rose 39 per cent from January to March 2023 compared to the first quarter of last year, which they describe as counterintuitive and seemingly resistant to increasing cost of living pressures and interest rate rises4 What the CBA does not report is that those driving the discretionary spending are distinct groups within an increasingly diverse population who are less impacted by interest rates rises. At the same tie the CBA was reporting high discretionary spending the Reserve bank April 2023 found that
“Lower income households are worst hit by rising interest rates and inflation” and “rising interest rates and high household expenses are weighing disproportionally on renters, first home buyers and those on lower incomes5
Their report identified mortgage prisoners, those with more than 15% of indebted homeowners can’t refinance because they no longer meet lending standards leaving them increasing their financial burden. These data were collected at when the cash rate was at 3.6%, since then rates have continued to rise. This group are not spending money on holidays and accommodation but rather struggling with supply and institutionally induced cost of living increases. For example, rent and power costs were major contributors to CPI. It makes little sense to devise interest policy predicted on reducing excess demand that penalises the groups least likely to engage in excess demand.
The heterogeneous nature of the Australian Economy
there are heterogeneous groups in the economy divided by income and wealth and, some of which appear to be untouched by interest rate increases. Consider the distribution of housing in Australia
n 2021, there were nearly 9.8 million households in Australia (ABS 2022). Where household tenure was known:
- 67% (6.2 million households) were homeowners
- 32% (2.9 million households) without a mortgage
- 35% (3.3 million households) with a mortgage
- 31% (2.9 million households) were renters
- 26% (2.4 million households) were renting from private landlords
- 3.0% (277,500 households) from state or territory housing authorities
- 2.4% (223,600 households) from other landlords.
In other words, 32% of households did not have a mortgage while of those 26% living in rental accommodation the large majority were aged under 30 years This housing distribution is indicative of the wealth distribution in Australia which is heavily skewed to older Australians and an increasingly smaller percentage of super wealthy
Us data found that increased aggregate demand in the United States is a fifth contributing cause of the current inflation but that 40% of the increased demand is coming from the wealthiest 1% and 75% from the wealthiest 10%,” It is highly likely that a similar impact has occurred in Australia
Interest rate manipulation is the e prominent and more often used aspect of monetary policy which also includes open market operations whereby the Commonwealth government buys and sells Government bonds to alternatively increase and reduce the stock of money in the economy. Yet even this has interest rate implications as nominal interest rate has an influence of the decision to buy or sell bonds. But the limitations of reliance on interest rate policy to influence the economy beyond thresholds is well known6
Why persist with interest rate policy alone
First, the RBA has a limited number of policy options that it can use, the chief of which is interest rates7. But interest rate policy is at best a fine-tuning device to steer the economy on an even balance between borrowers and lenders. It is best used for only minor corrections to the economy are needed, for example when the inflation rate nudges above the 3% band They should not be used to control accelerating inflation. Second, and some seem this as a strength, the RBA is independent. Consequently, they do not necessarily act in coordination with Government policy. As a result, we have the current situation in Australia where RBA fight on inflation can be undercut by excess Government spending and wage decisions. In one of his more famous quotations Milton Friedman claimed Governments are invariably the cause of inflations (https://youtu.be/F94jGTWNWsA)
Third, successive Governments have an aversion to using fiscal policy such as tax increase for higher earners and windfall taxes on suppliers that take advantage of supply constraints to soak up the extra money which is the source of much of the excess demand. In short, the current policy of interest rates rises to combat inflation is a combination of ineffective and insufficient RBA policy options, they have no fiscal powers, and need to content with dealing with Government policy which is often counterproductive.
What other policies to try.
It is bordering on immoral that the current policies to reduce inflation target those least responsible for the inflation and least able to pay for it. These are a several policies worthy of consideration
Increase tax rates for the wealthy including the re-introduction of dearth duties ( on a federal level)
- This is needed to instead of effects to control general demand but rather the demand by the wealthiest 10%. This is best achieved not by raising interest rates but by increasing taxes on those who are already rich, for whom inflation is not problem.
- Synchronize RBA policy and Government policy to remove inconsistencies which reduce the effectiveness of interest rate policy.’
- Re introduce a government bond scheme like the US Ov buy bonds scheme to soak up excess cash in a safe investment environment.
- Give the ACCC and ATO some teeth to counteract transfer pricing and price gouging.
- Reduce migration intake to ease housing and rent pressures.
In summary, Australians have endured 14 interest rate rises with little impact on inflation but major impact on the most vulnerable in the society. Surely there are better ways to solve an economy wide problem.
- See, Huang, K. and Liu, Z (2005) “Inflation Targeting: What inflation target to target” Journal of Monetary Economics 52(6) 1435.1462 ↩︎
- Mishkin, F, and Westelius, N.( 2008) “Inflation Band Targeting and Optimal Inflation Contracts” Journal of Money, Credit and Banking 40 (4) 557-581 ↩︎
- Brunnermieier, M (2023) “Rethinking Monetary Policy in a Changing World”, International Monetary Fund, Finance and Development , March 2023 https://www.imf.org/en/Publications/fandd/issues/2023/03/rethinking-monetary-policy-in-a-changing-world-brunnermeier ↩︎
- See Comm Bank IQ Cost of Living Insights Report, May 2023 ↩︎
- Cited in theguardian.com/australia-news/2023/apr/06/lower-income-households-worst-hit-by-rising-interest-rates-and-inflation-rba- ↩︎
- Stiglitz, J (2022) “Raising interest rates to Fight Inflation will only Cause More Pain, cited https://www.theguardian.com/business/2022/dec/09/raising-interest-rates-inflation-central-banks-recession ↩︎
- See. IMF (2022) Monetary Policy and Central Banking https://www.imf.org/en/About/Factsheets/Sheets/2023/monetary-policy-and-central-banking ↩︎
