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RBA not on a pre-set interest rate path

Petrol prices in Australia are up by 37 per cent over the past year, which alone is adding around 1 percentage point to headline inflation. Another example where disruptions to global production are having an effect in Australia is the price of new cars, which has increased at the fastest rate for many years.

As important as these global influences are, they do not provide a full explanation for higher inflation in Australia.

Domestic factors at play

Increasingly, domestic factors are also at play. Following the strong recovery from the pandemic, growth in domestic spending is now testing the ability of the economy to meet the demand for goods and services.

This is particularly evident in the labor market, with many firms reporting that the availability of labor is a significant constraint on their ability to operate and/or expand. Many parts of the construction sector are also operating at, or close to, full capacity. And some public infrastructure investment is being delayed or scaled back because of capacity constraints.

Not surprisingly, this pressure on domestic capacity has led to a broadening of inflation pressures in Australia. Reflecting this, the share of items in the CPI basket with annualized price increases of more than 3 per cent is at the highest level since 1990.

When the RBA published its latest set of forecasts in early May, we expected that inflation would peak around 6 per cent at the end of this year. The information available since then has led us to push this forecast peak higher.

Since early May, petroleum prices have risen further due to global developments, and the outlooks for retail electricity and gas prices have been revised higher due to pressures on capacity in that sector. As a result, we are now expecting inflation to peak around 7 per cent in the December quarter.

Following this, by early next year, we expect that inflation will begin to decline. I would like to highlight three factors that lie behind this assessment that inflation will moderate next year.

The first is that some of the pandemic-related supply-side problems in the global economy are gradually being resolved.

Firms have been adjusting to their new operating environment and solving the problems in global production and logistic networks. As a result, delivery times have shortened a little since last year, the prices of semiconductors have declined from their recent peak, and the global production of cars is showing signs of a recovery.

While it is still possible there will be further setbacks, the global production system is adjusting and this should help lessen some of the inflationary pressures.

The second factor is a more technical one, but one that we should not lose sight of. It is important to remember that inflation is the rate of change of prices. It is not a measure of the level of prices.

This means that for inflation to stay high, prices have to keep increasing at an elevated rate; if prices simply remain steady at a high level, the rate of inflation falls to zero. As an example of this, if global oil prices were to stay at the current elevated level, the annual rate of increase in oil prices would fall from 66 per cent to zero per cent. This might not be of much comfort to people struggling with the high level of prices, but it would mean that the rate of measured inflation would decline.

The third factor that provides confidence that inflation will decline is the tightening of monetary policy that is under way around the world, including here in Australia. The higher interest rates globally will help to create a more sustainable balance between the demand for goods and services, and the ability of our economies to meet that demand.

Achieving that balance is not straightforward and there are risks involved, but higher interest rates will lessen the inflationary pressures.

Prepare for more rate increases

This brings me to the Reserve Bank board’s recent decisions. In May, the board increased the cash rate target by 25 basis points and, in June, by a further 50 basis points. These were the first increases in the cash rate since 2010.

The board is committed to doing what is necessary to ensure that inflation returns to the 2 to 3 per cent target range over time. High inflation damages the economy, reduces the purchasing power of people’s incomes, and devalues ​​people’s savings. It is also regressive, hurting most those who are least well-equipped to protect themselves.

So, it is important that we chart our way back to an inflation rate in the 2 to 3 per cent target range. We do not need to, nor can we, get there immediately.

Australia has long had a flexible medium-term inflation target which, by design, can accommodate deviations of inflation from target. For a number of years, inflation was below target, and now it is above. What is important here is that we chart a credible path back to an inflation rate of 2 to 3 per cent.

That path will be easier to navigate if the inflation psychology in Australia does not shift too much. A lesson from the 1970s is that if an inflation shock shifts people’s expectations about the ongoing rate of inflation, it becomes harder to reverse.

Applying this lesson to today, it is important that the higher rate of inflation this year does not feed through into ongoing inflation expectations. If it did, the period of higher inflation would persist and it would be more costly to reverse.

To date, medium-term inflation expectations have been well anchored around 2 to 3 per cent, suggesting that people believe we will get back to target. We want to do what we can to make sure this remains the case.

Higher interest rates have a role to play here, by helping ensure that spending grows broadly in line with the economy’s capacity to produce goods and services. Higher interest rates can also directly affect expectations by demonstrating the commitment of the RBA to return inflation to target.

As we chart our way back to 2 to 3 per cent inflation, Australians should be prepared for more interest rate increases. The level of interest rates is still very low for an economy with low unemployment and experiencing high inflation.

I want to emphasize, though, that we are not on a pre-set path. How fast we increase interest rates, and how far we need to go, will be guided by the incoming data and the board’s assessment of the outlook for inflation and the labor market.

As we make that assessment each month, the board will be paying close attention to developments in the global economy, the evolution of labor costs, and how household spending is responding to higher interest rates.

Household balance sheets are generally in good shape, with households overall having accumulated more than $200 billion in additional savings during the pandemic.

Furthermore, the current rate of saving out of income remains materially higher than it was before the pandemic, so there is a degree of flexibility in many household budgets. It is also relevant that strong employment growth is continuing and that there are many job opportunities at the moment.

However, on the other side of the ledger, many households have not previously experienced a period of rising interest rates. Households are also experiencing a decline in real incomes because of the higher inflation, and some of the large gains in housing prices over recent years are being unwound.

Given these various considerations, we will be watching household spending carefully as we chart our way back to 2 to 3 per cent inflation.

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