Why the RBA can still be patient on interest rates

The reason Lowe still has time on his side is that this week’s numbers suggest that while Australian inflation picks up, it’s nowhere near as high as in other countries like the US, the UK or New Zealand. We’re also still missing something the RBA has been trying to engineer for years: higher wage growth.

To understand why Lowe doesn’t face the same urgency to raise interest rates as some of his peers overseas, it’s worth reviewing some basic central banking principles.

Monetary policy – the change in interest rates – is central bankers’ main tool for keeping inflation within the long-term target range. But rates are an “extremely blunt instrument,” meaning they affect the whole economy, not just specific parts of it.

Markets will be glued to what RBA Governor Philip Lowe has to say about the evolution of inflation and interest rates next week.Credit:Louie Douvis

Therefore, central bankers often say they can “look through” inflation that they think is temporary.

Last year, that was the argument we heard from Lowe. As inflationary pressures built up overseas, the RBA was of the view that the price increases were mostly temporary and resulted from shortages of goods, which would subside over time.

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But in recent months it has become clear that price increases abroad are more than temporary, particularly in the United States, where inflation is now near a 40-year high of 7% a year.

Australia’s inflation rate is half that, but data this week showed widespread price increases, including in fuel, food, clothing and footwear, national holidays and transport.

The crucial question is whether these price increases are one-time or something more fundamental that will persist.

Most market economists say that it is no longer credible to regard inflation as “transitory”. But after so many years of missing the inflation target, Lowe also stressed that he would not raise rates until inflation was “sustainable”.

Have we reached this level yet? Probably not.

It should be noted, for example, that the consumer price index showed a rise in the price of goods of 4.3%, well above the rise of 2.3% in the price of services. This matters because commodity prices have been under the most pressure of late due to the disruption of global supply chains. Sharp price increases for some imported goods may well slow in the coming months as supply chains recover.

By the end of the year, we may be at the point where compensation packages are growing fast enough to convince the RBA that it’s time to start raising rates from virtually zero. The day always came, but it could come sooner than many thought.

Rather than supply chain bottlenecks, a greater influence on inflation (and therefore interest rates) will be what happens to wages. Indeed, wages have a chicken-and-egg relationship with inflation: as prices rise, people demand higher wages, which in turn increases costs for businesses.

Lowe has repeatedly said that for inflation to be sustainably in the RBA’s 2-3% range, we probably need wages to rise by around 3% a year. It is trying to achieve this by keeping rates close to zero, hoping to allow the labor market to become so tight that employers will have no choice but to pay their staff more.

The latest official numbers suggest Lowe still has a long way to go to engineer bigger pay rises. Wage growth was just 2.2% a year in the September quarter – but of course the labor market has tightened considerably since then.

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Earlier this month, the ABS said unemployment fell to just 4.2% in December, its lowest level since 2008. Many economists believe this is approaching the level that will be needed to force employers to start giving bigger pay raises – as is already happening in some countries. -sectors of demand.

So, by the end of the year, we may be at the point where compensation packages are growing fast enough to convince the RBA that it’s time to start raising rates from virtually zero. The day always came, but it could come sooner than many thought.

At present, however, there is no evidence that wages are rising fast enough to warrant the RBA starting to raise rates to more normal levels.

Ross Gittins is on leave.

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