RBA's Aggressive Interest Rate Hikes: A Balancing Act between Inflation and Employment
Earlier this month, the Reserve Bank of Australia raised interest rates yet again. Today, the cash rate stands at 3.85%, which is the highest it’s been in 11 years. The hikes have come thick and fast. In fact, they’ve been steeper than with most historical rate hikes, which is testament to the truly unique nature of the global macroeconomy right now.
Economic policy is all about managing trade-offs, and whilst rate hikes can help cool off high inflation, it can have an impact on jobs and unemployment.
The RBA's Interest Rate Strategy
With the EU, UK, and US all hiking rates over the past 12 months, it’s clear that Australia is also affected by the global situation. The invasion of Ukraine, along with supply chain issues and a hangover from Covid-19 has brought on rampant inflation in much of the West.
Australia has also suffered from inflation, as it currently stands at 7% - far above the RBA’s target 2-3%. It’s not just rising food and transport costs that is underpinning the rate hikes though. RBA governor, Philip Lowe, mentioned the rising rents in Perth and the issue of limited supply after his recent rate hike.
Currently, there’s a low pass through of the RBA hikes. That means that the hikes are not being reflected in proportion by banks, so the impacts of such the current contractionary policy is less than expected. One reason for this is that many borrowers have a fixed-rate mortgage (which will expire later in the year). But, it may also be because banks are reluctant to pass on the rising costs to customers due to competitive pressures. This could lead to other forms of quantitative tightening by the RBA, such as selling bonds and increasing yields that way.
The Impact on Inflation and Jobs
The RBA was advised that, at the cost of around 200,000 job losses, they could bring inflation down to the 2-3% target by around late 2024. Besides being far more modest of a timeframe than the UK’ BoE, the modelling showed a fairly straightforward choice that all economists are familiar with: the inverse relationship between inflation and employment.
The relationship exists because as interest rates rise, the cost of debt rises. Being an unfriendly business environment, along with incentivising high savings accounts over spending, means there are fewer jobs.
ABC report that Lowe told a gathered crowd after the last rate hike, "We have seen further evidence that the Australian labour market is still very tight, that services price inflation is proving to be uncomfortably persistent abroad, and that asset prices — including the exchange rate and housing prices — are responding to changes in the interest rate outlook".
The closer an economy is working at its full capacity, meaning demand-pull growth and low unemployment, the higher inflation can run. But, unlike much of India’s current demand-pull growth and subsequent 7% inflation, Australia’s situation is not born out of an economy working to its full capacity, it’s due mostly to supply-side factors.
This makes inflation hikes a harder pill to swallow - you’re cooling off an economy that isn’t even hot. Real GDP growth stands is projected to reduce from a forecasted 1.9% in 2023 to 1.6% in 2024.
Nevertheless, inflation, like unemployment, are key factors in the current cost of living crisis. Generally, economists opt for prioritising inflation, because price stability is extremely important for investment, business, certainty, confidence, and has more long-term ramifications.
Expert Opinions
Treasurer Jim Chalmers told the ABC that “the situation in the world has become more complex and more challenging even over the course of the last few months. We won’t be completely immune from that.”
Dean Atterli at MNY Australia highlights that "In an aggressive pursuit of inflation control, the Reserve Bank of Australia faces a precarious balance between reining in inflation and potential job losses, a testament to the delicate dance central banks must perform in managing economic health."
One area of possible strength for Australia’s domestic job market is that there have been labour mobility issues. A KPMG report highlights that affordable airline capacity, visas, and increased competition from abroad regarding skilled migrants has led Australia to turn to its own workforce over the past few years. And, KPMG expects that with the reopening of China, Australia should see positive growth momentum in 2023 which could positively impact employment.
The IMF, however, is less positive, as they see Australia facing “perilous” challenges. The IMF focuses heavily on the global situation, which is going to see a reduction in growth this year, and how this impacts Australia. Deloitte’s recent report shows the same emphasis too, along with concerns over the RBA triggering the slowest economic growth in Australia since the 1990s recession.
The Deloitte Access Economics' Business Outlook Report, by Stephen Smith, claimed “Our view remains unchanged – the additional 50 basis points of increases earlier this year were unnecessary, and have prompted a further downgrade in Australia’s growth outlook”. Around 300,000 Australians are estimated to now have a negative cash flow.
Comparisons with Other Economies
Compare Australia's situation with other countries dealing with similar issues. This could include, for instance, the U.S. jobs crisis. How have their central banks responded, and what have been the outcomes?
Both the US and Australia have shared a strengthening job market since 2020. And, whilst inflation hasn’t been demand-pull, wages have been rising in response (though not in proportion) to rising living costs.
The US and UK have been aggressive in their interest rate hikes, currently sitting at 5.25% and 4.5% respectively. The UK has had a couple of serious repercussions from this so far, namely the gilt market crisis, in which they spiked bond yields. This hurt liability-driven investment strategies (who play a large role in UK pensions), leading to a fire sale of gilts. The Bank of England had to step in and purchase some gilts for stability.
KPMG expects the UK to see -0.3% growth in 2023 from the interest rate increases. The US’ forecasts are a bit more positive, however, the strong employment market in the US is of concern to Deloitte, who think that it may cause unsustainable wage growth. Deloitte is still undecided on whether the 2022 hikes were too fast, but it so far seems they weren’t enough to push the US into a recession.
Conclusion
The Reserve Bank of Australia has a similar approach to dealing with inflation as other major economies right now. And, seeing as the hikes are less than many other central banks, yet employment is currently very strong, it appears that most economists agree on prioritising preventing a wage-growth spiral over increasing unemployment.
Australia, as is often the case, is in a strong position. Inflation does appear to be easing, and if further interest rate hikes (or the low pass through) is of concern, the RBA has other quantitative tightening tools at its disposal. One thing is for certain, though, which is that Australian banks are at a lower risk of a bank run than US and European banks, meaning they have more freedom with their monetary policy strategy.
