The recent decision by the RBA to raise interest rates may have surprised some people. While some argue that rates have already increased significantly and coupled with rising living costs, this could eventually control inflation, it is important to recognise the persistent threat that high inflation poses to an economy.
Furthermore, central banks aim to avoid repeating their past mistake of being too slow to adjust interest rates, as they don’t want to risk inadequate action in curbing inflation, which could further erode their credibility.
However, I have concerns regarding the effectiveness of increasing interest rates as a tool to curb inflation. They are a rather blunt instrument and raising rates gradually starts to feel a bit like ‘death by a thousand cuts’.
Will increasing interest rates help reduce inflation?
Using interest rates to control consumer spending has its limitations because they function as a blunt tool. This is primarily because not all Australians have a home loan. Approximately 30% of Australians own their homes outright, 37% have a mortgage and 26% rent from private landlords. Therefore, interest rates only directly affect 37% of the population and 26% indirectly as renters.
One drawback of raising interest rates is that it disproportionately impacts lower-income borrowers compared to higher-income borrowers. Additionally, higher interest rates can make it more difficult for renters to enter the property market due to stricter borrowing conditions. In essence, higher interest rates exacerbate wealth inequality.
In a blog I wrote in June, I referenced historical research that suggests inflation tends to be persistent. It typically takes an extended period for inflation to drop below 3% per annum, with an average of 11 years to achieve this.
Labour costs and productivity are a major challenge
Why is inflation so persistent? The RBA has hiked interest rates by 4.25% over the past 19 months – shouldn’t inflation be under control already?
I recently came across a post on Twitter where someone expressed concern about the cost of a takeaway coffee, priced at $7.60. They pointed out that the price of coffee beans has fallen by 18%, and milk prices have decreased by 10-23% over the past two years. However, wages, energy costs and insurance premiums have all risen during the same period. This example highlights the significant challenge businesses face due to rising labour costs.
According to the Australian Bureau of Statistics (ABS) wage price index, private sector wages have increased by 6.6% over the past two years. In some sectors, wages have risen even more, with increases of 20% to 30% or even higher. This is particularly evident in sectors with a tight labour supply, such as the labour market for experienced accountants, which is currently at its tightest in more than 20 years. Consequently, accounting firms are offering substantially higher remuneration than a few years ago to attract and retain staff.
Alongside the increase in wage costs, there has been a significant decrease in productivity, with a nearly 30% decline in output per hour over the past decade. This decline has pushed productivity to its lowest level since World War II.
Employees today expect a greater degree of flexibility compared to a decade ago, including options like working from home and flexible work hours. While this flexibility can be advantageous for both employees and employers, it also brings added responsibility. If employees fail to maintain their productivity levels, this newfound flexibility may not be sustainable in the long term.
Wage-price inflation spiral
A wage-price inflation spiral is an economic situation in which increasing wages trigger higher prices, which then result in calls for even higher wages. I have noticed several instances where businesses had to significantly raise wages due to a competitive labour market. This surge in wages drives up the demand for goods and services, ultimately contributing to inflation.
To address this phenomenon, the key solutions involve reducing the demand for labour, increasing the supply of labour, and enhancing productivity. These actions can help break the cycle of wage-price inflation and promote economic stability.
Savings and lack of competition
Two additional factors may be playing a role in the persistence of inflation.
Firstly, Australians have been able to amass an unusually elevated level of savings in recent years, primarily due to factors like low-interest rates. These accumulated savings function as a cushion against the impact of higher interest rates and can postpone a decrease in consumer spending.
Secondly, Australia’s economy faces a lack of competition in several industries. The four major banks dominate the financial services sector, while the two major supermarket chains collectively control over 60% of the market. Similarly, a single major airline holds a substantial market share, also around 60%. It can be argued that Australia experiences less price competition compared to international markets due to this concentration of market power.
The benefits of a recession
Australia has avoided a recession for over 30 years. Surprisingly, this prolonged period of economic growth also has its drawbacks. A typical economic cycle of booms and busts offers certain long-term advantages, including:
- Cleansing effect & improved productivity. It allows inefficient or poorly managed businesses to fail making way for innovation and competitive companies to emerge. In addition, highly competitive, crowded industries with minimal profitability benefit from thinning out. This forces many businesses to become more productive leading to a more robust and efficient economy in the long run.
- More realistic allocation of capital. During a recession, many businesses and individuals re-evaluate investment returns, risk, and the resultant value of assets including shares and property. This can result in a reweighting of valuations. This can lead to a greater focus on savings, investing wisely and long-term financial planning, helping people make better financial decisions in the future.
- Lower inflation. Recessions can help control inflation by reducing demand for goods and services. This can be beneficial for individuals and businesses, as it helps maintain the purchasing power of their money.
Maybe the RBA should go hard and push Australia into a recession.
While the prolonged period of economic growth in Australia has its benefits, it is important to recognise that a balanced economic cycle, including periods of recession, can offer these advantages, contributing to a more dynamic and resilient economy in the long run.
I want to clarify that I am not suggesting that the RBA intentionally causes a recession. The aim of this discussion is to highlight certain structural weaknesses in Australia’s economy and question the effectiveness of using interest rates as a primary tool. Rather than relying solely on interest rates to address inflation, which can be a gradual and painful process for some cohorts of the population, maybe the RBA should consider using interest rates to deliberately induce a recession. The idea behind this approach is that it might lead to increased productivity and competition while also helping to stabilise inflation levels. To use an idiom, maybe the RBA should “rip off the Band-Aid”.