Reserve Bank in danger of causing an economic recession

The Reserve Bank of Australia is lifting interest rates in an attempt to curb inflation but risks an economic recession by doing so, writes Matthew Smith.

IN ONE OF the last scenes of the 1973 film Magnum Force, Clint Eastwood says famously of his departed corrupt police boss, “A man’s got to know his limitations”. Well, it is important that central banks also know their limitations in the conduct of monetary policy, otherwise they may inflict harmful effects on their national economy.

This understanding is now particularly pertinent as the Reserve Bank of Australia (RBA) continues to lift interest rates into territory which potentially risks pushing the Australian economy into a recession late next year in line with the outlook for a serious downturn in the world economy.

Since 4 May this year, the RBA have in little over seven months increased the cash rate by 2.75% to a target rate of 3.1%, causing mortgage rates on owner-occupied housing to typically increase by over 2.5% to rates now close to 5%. On a typical 30-year home mortgage of $500,000, this implies an increase in monthly loan repayments (principal and interest) of approximately $700. Given recent concerns about the trends in price inflation as expressed in their monthly monetary policy statements, the RBA is likely to further lift the cash rate early next year.

This raises the question: how high is the RBA willing to raise rates to achieve its primary objective of bringing “core” price inflation, now standing at 7%, down to its 2-3% target? And over what time frame? Is the RBA willing to risk a recession to achieve this objective? The answer to these questions in our view revolves around what the RBA understands to be the limitations of monetary policy.

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There are two key points about monetary policy setting that are made when teaching economics undergraduates that are relevant here. Firstly, central banks have always set inflation targets within the range of the existing inflation rate. Hence, in Australia, when the RBA’s target of 2-3% per annum of the “trimmed mean” price inflation (based on the Consumer Price Index) was set in 1996 under an agreement with the Government, the actual average annual inflation rate was about 2.6%.

Since then, the inflation rate has only intermittently and temporarily risen above the target maximum up until the end of 2021. The capacity of the RBA to keep within the target has no doubt been assisted over this time by the structural changes in industrial relations which have weakened the wage-bargaining power of Labor and, connectedly, by the slow trend growth of the last decade.

Secondly, should a supply shock cause price inflation to rapidly and unpredictably increase to rates well above the target, a central bank may be compelled, partially because of political constraints, to push out the time frame for again achieving it, or to adjust it all together. Thus, in the case in which a war causes energy costs to increase by four-fold, akin to what happened with the oil price shock of the early 1970s, which causes price inflation to rise above double figures, it would not be possible for a central bank to foreseeably achieve a 2-3% target without inducing a major economic recession. A similar situation to this latter scenario is now what confronts the RBA.

In Australia, the RBA treats its inflation target as “flexible”, which means ‘that inflation does not need to be in the target range at all times, but rather, on average, over time’ so that inflation ‘affected by temporary influences, such as supply disruptions or a tax change’ should not cause a monetary policy response. However, the problem facing the RBA is that the supply disruptions fundamentally causing the increase in price inflation are not temporary but ongoing and persistent.

The upward pressures on worldwide energy prices which is the main cause of high price inflation will persist until the Western world adjusts to the loss of Russian gas supply, certainly whilst the war in Ukraine continues, but even after it ends. Only a swift end to Russian President Vladimir Putin’s presidency and a backflip in Russian foreign policy could relieve the current pressures.

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In this connection, the structural problems in eastern Australia’s energy market to transition to lower-cost renewables, a result of a decade of policy chaos motivated by support of the fossil fuel industry, will not be resolved in the short run. Another significant contributor to high price inflation is the housing crisis in Australia which has seen rent for tenants on home leases skyrocket, a situation unlikely to be resolved in the short term.

Other major contributing supply disturbances, such as global supply chain interruptions placing upward pressure on the prices of a range of imported manufactures and the succession of floods experienced in agricultural regions causing an increase in food prices, may not be so persistent.

This brings us to the limitations of monetary policy. As is well known, putting aside effects on the exchange rate, a tightening of monetary policy through the lifting of interest rates operates to alleviate price inflation. This is mainly done by slowing down the aggregate demand for products in relation to productive capacity, thereby creating greater unutilised capacity associated with higher rates of labour unemployment.

Perhaps what is less well known is that higher rates restrain domestic demand mainly through their direct effect on consumption rather than investment spending. Other than commercial and residential construction, investment (in productive capacity) is mainly affected indirectly via suppression of household expenditure on final consumer products (consumption).

In Australia, the transmission of monetary policy is highly effective because of the large mortgage debt in the household sector stemming from the high and rising prices of urban housing over the past 30 years and of heavy reliance on private rental housing. It means that an increase in the RBA’s cash rate, inducing enlarged increases in home lending rates by the commercial banks, will squeeze discretionary expenditure by households as mortgage debt holders meet the increase in home repayments and renters meet the increase in house rents charged by debt-holding landlords.

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The steep increase in rates has already seen house rents rise considerably in the home rental market with near-zero vacancy rates in most capital cities, whilst the impact on home mortgage holders will progressively intensify into next year as low-rate fixed-term loans mature and they are forced onto higher variable loan rates. Fundamentally, the policy works by forcing up the cost of living of home renters and mortgagees, intensifying the overall cost of living in society, something which involves a redistribution of income away from the household sector to the profits of corporate banks and mortgage lenders and to low-risk liquid wealth funds.

The main goal of the RBA’s policy appears to be to contain current inflationary pressures by slowing economic activity to prevent inflation from feeding into higher inflationary expectations and wage growth. The problem facing the RBA in its goal to bring the inflation rate back down to its policy target is that lifting interest rates does not resolve the persistent supply difficulties fundamentally causing the current inflationary pressures.

High interest rates do not end the war in Ukraine, resolve the dysfunctional state of Australia’s eastern energy and gas market, alleviate the rising costs of climate change (insurance and food) or overcome a national housing crisis.

Besides these limitations, the current monetary policy also contributes directly to higher price inflation. As mentioned above, in the current tight housing market with unprecedentedly low vacancy rates, higher rents have already stemmed from interest rate increases, contributing to a higher consumer price index and measured price inflation.

Moreover, if higher interest rate levels persist, it will generally increase the cost of capital which will cause firms to raise prices to sustain their profit rates based on normal levels of activity consistent with competitive conditions. Of course, by lifting rates high enough, the RBA can always overcome these tendencies by depressing economic activity.

But if the RBA is not guided by its limitations and attempts to achieve its target too expeditiously and before the current structural supply problems are resolved, then its anti-inflationary policy may result in an unwanted severe economic recession. And, if that happens, the RBA will have failed even if it achieves its inflation target.