What words do you least want to hear from your central banker? “I’m not expecting there to be a recession, but… we’re on a narrow path.” They were spoken by RBA Governor Philip Lowe last month to a conference of central bankers in the global prudential capital of Zurich.
So, how wide is this road?
- There are times when monetary policy is easy and your range of good choices is wide. Like driving a car on a flat road on a dry day, you can drive with one finger or jiggle the steering wheel and both are fine.
- There are times when monetary policy is hard and your range of good choices is very small. Like driving a race car in the rain — you need clear vision, strength and precision timing to avoid a horrible crash.
- There are times when you’re done for no matter what. Like if the semitrailer in the next lane has tipped over and, while you may have a moment to watch it tumble onto the roof of your car, there’s no way to move. You will try to do fast, heroic things but they are in vain: your fate was sealed at a time in the past.
Australia is going to find out whether we are in scenario two or three. The RBA has either a small chance to get things right — or perhaps no chance at all.
Unlike the automotive scenario, where the speed of physics determines the outcome, our situation will be determined by the speed of transmission of monetary policy, which is measured in years. While our fate may be sealed, we have time to talk about it at least. Not least this week, as the RBA today unrolls what is expected to be the second in a series of significant 0.50% rate rises.
As the next chart shows, interest rate expectations have gone up a lot recently. However, suddenly the pattern is more varied: while expectations for near-term rates are at record highs, expectations for later rates have moderated.
There are two ways to read that: markets think the RBA’s bold action will solve our inflation problem, or markets think the RBA’s bold action will cause other problems. Either way, there won’t be such a need for high interest rates in late 2023, as markets foresaw just a few weeks ago.
How high inflation?
With inflation high and rising, but largely determined by imported goods, the RBA has a dwindling capacity to push back. It may suppress wages, it may suppress rents. But it cannot do much to suppress energy prices nor the prices of manufactured goods, such as food, computer chips, cars, etc. Note that it doesn’t matter if these things come from overseas or go overseas. Tradeable goods are just those that have their price set in global markets.
As the next chart shows, we are used to inflation in tradeable goods being low — scarcely above zero each quarter. Now it is very high.
“Global supply chains are long and complex and it turns out if there is a problem anywhere in the chain then it reverberates right through the system and keeps putting prices up,” said Lowe at that same conference. “We’re still getting price pressures from supply chain disruptions.”
We can make our dollar stronger by raising rates — in theory anyway — and that strength makes imports a little cheaper. But when every other central bank is also hiking, we are really just running to stand still. And with all that running we could do ourself a mischief.
The big risk is interest rates rise enough to squash the economy, reverse employment growth, and make our current flirtartion with full employment a distant memory of what might have been — and yet that is not enough to quell a rising consumer price index. And then there’s housing.
The national obsession
“I presume housing prices are going to adjust further downwards, so that’s another dynamic affecting household balance sheets,” said Lowe.
Consumer confidence is already plumbing depths Jules Verne scarcely conceived of, and the house price falls have only just begun. Once the rot sets in — and most big banks think it will be a one- or two-year reversal — Australian household perceptions of their own wellbeing could get pessimistic indeed, with consequences for retail spending and the jobs retail spending props up.
The RBA is in a heck of a tight spot. It needs to make a lot of people unhappy on the way to squashing inflation. We may hope inflation proves soft and yielding and the pain is brief.
