The market thinks rates are about to go up because of inflation. The market could be wrong

·4 min read
<span>Photograph: Richard Milnes/REX/Shutterstock</span>
Photograph: Richard Milnes/REX/Shutterstock

Why not take Australia’s Reserve Bank at its word? It will hold fire on interest rate rises until there’s higher wages growth


The latest Australian inflation figures showing strong prices growth in the past six months have once again put interest rate rises into the frame. A rate rise during a May election campaign is raised as a possibility, but the Reserve Bank might be a lot less willing to move than speculators believe.

This year, inflation has been all the economic rage. In America, questions about it led to US president Biden referring to a Fox News journalist as a “dumb son of a bitch” while here in Australia we are at a point where, if the market is to be believed, a rate rise could occur by May.

Tuesday’s consumer price index figures showed prices grew by 1.3% in the last three months of 2021, and 3.5% through the whole year.

Underlying inflation – which the Reserve Bank is more concerned about when it comes to setting interest rates – at 2.6% was nicely within the RBA’s target band of 2%-3%:

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As a result, the market now expects the Reserve Bank to raise the cash rate to 0.25% by May and up to 1% by the end of the year:

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But whether the Reserve Bank will actually increase rates is something a bit more complicated than just hoping money market speculators have got it right.

Related: Inflation in Australia might be on the rise, but it’s hardly running wild | Greg Jericho

Mostly it comes down to whether inflation needs to be tempered, and whether raising interest rates will do anything to temper that inflation.

You can see why economists around the world are rather fixated on inflation at the moment. In the US prices rose in 2021 by 6.7% – and US prices often lead the rest of the world, including Australia:

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A key reason is items such as oil.

Petrol prices were a major contributor to overall inflation. Since the start of the pandemic, petrol prices have risen around 70%:

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That is overwhelmingly driven by the world oil price:

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Nothing the RBA does with the cash rate will affect how much we pay for petrol.

But then there are house prices. These were also a big contributor to price rises both in the December quarter and throughout 2021:

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Here the Reserve Bank can definitely influence prices.

But as I noted earlier this month, housing finance has already come off the boil. It might be the case that raising the cash rate now would do little to influence house prices given the withdrawal of stimulus measures designed to prop up the housing market, such as the homebuilder program, is already doing that.

And while house prices do need to be tempered, the RBA has more tools at its disposal than just interest rates. Together with the Australian Prudential Regulation Authority (Apra) it can further tighten lending standards, it can end its bond buying program and it can also give guidance about a change in approach that can attempt to “talk down” the market.

Because, while house prices have gone mad, rather interestingly the annual growth of “non-tradable” items (those items not influenced by international prices) actually fell in the December quarter from 3.2% to 2.8%. They are now well down on the June 2021 quarter peak of 4%:

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This matters because since 2000, the Reserve Bank has only once raised the cash rate in a period when non-tradable items rose by less than 3% – and that was straight after the GFC.

Given the price growth of these items is actually falling, that suggests there is little need for the RBA to hit the brakes.

Similarly, out of the 88 sub-groups in the CPI basket, only around 30% are growing by more than 3% annually – that is well below the level we saw before the GFC when the RBA was hiking rates:

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But all of this ignores the big factor that is driving inflation: supply blockages.

Anyone who has bought something from overseas, tried to buy a new car, or even hoped to buy meat at a supermarket, knows what I am talking about.

Inflation is driven by two things: increased demand – more people wanting to buy something – and reduced supply – less availability of a thing the people want to buy.

If overly strong demand is the problem, then raising interest rates makes sense; if it is a lack of supply, then raising interest rates might just reduce a demand that is not actually all that strong.

For this a better guide is not prices but wages. And here we would be well served to actually listen to what the RBA says.

In the minutes of its December board meeting, the board concluded it “will not increase the cash rate until actual inflation is sustainably within the 2 to 3% target range. This will require the labour market to be tight enough to generate wages growth that is materially higher than it is currently.”

“This,” the board concluded, “is likely to take some time and the board is prepared to be patient.”

Until wages are growing by at least at 3% we probably should not get too excited about possible rate rises.

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