Australian Economy

Inflation and interest rates in Australia are set to increase further. This is what it means for you

From petrol to vegetables – the price of just about everything has risen over the last few months.

And while goods aren’t about to get any cheaper – there is an end in sight.

By the end of the year, inflation is predicted to peak at 7.2 per cent, according to new data released this month from NAB, well above the Reserve Bank of Australia’s 2-3 per cent goal.

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“It just means the stuff that average consumers buy … is going to go up in price even more,” senior economist at The Australia Institute Matt Grudnoff said.

“Above 7 per cent is historically very, very high. We don’t usually see inflation rates that high.

“Obviously, if prices are going up quickly and your wages aren’t going up as fast, then the total amount of stuff you can buy is going down.

”So your real wage is actually going down. That is, you can buy less stuff with your income.”

Imported inflation

Earlier this month, RBA Governor Philip Lowe said global inflation was being boosted by COVD-related disruptions to supply chains, the war in Ukraine and strong demand putting pressure on productive capacity.

“Inflation in Australia is also high, but not as high as it is in many other countries,” Lowe said in July’s monetary policy decision statement.

“Global factors account for much of the increase in inflation in Australia, but domestic factors are also playing a role.

“Strong demand, a tight labour market and capacity constraints in some sectors are contributing to the upward pressure on prices. The floods are also affecting some prices.”

Consumer Price Inflation since the mid-1990s. Credit: RBA/ ABS

But because most of the inflation is imported, there’s not a lot the government can do to help ease the pressure off Australians, The Australia Institute senior economist Grudnoff said.

“This is actually a rarer kind of inflation called cost-push inflation,” Grudnoff said.

“If the government made a big policy announcement, that’s not going to change the world price of oil, for example.

“So there’s not a great deal that the governments can do other than compensate those that are most adversely impacted by the inflation, there isn’t a great deal they can do to actually bring inflation down.”

How long will this last?

After a peak at the end of the year, inflation is expected to ease in 2023 as growth slows globally and the impact of supply shocks begin to wane.

“The other thing too is to remember with this kind of supply shock inflation is that it’s often a one-off event or a series of one-off events,” Grudnoff said.

“Inflation’s actually the ongoing increase in prices, so prices have to keep going up for inflation to remain.

“Often these supply shocks have an initial impact and then they flatten out.

“So the oil price initially goes up, but then if it flattens out at that level, we’re not going to see further inflation from it.

“So long as you don’t have a wage price spiral … where prices and wages zoom up, which we haven’t seen any evidence of so far, then the inflation isn’t likely to be ongoing.”

What role do interest rates play?

The RBA has increased interest rates to 1.35 per cent over the last few months, as the country emerged from the COVID pandemic.

NAB predicts the central bank will increase rates further over the last two quarters of the year and early next year, with a 50 basis point increase in August and another 25 basis point increases in September, November and February.

The RBA is doing this to tackle inflation and to adjust rates towards a neutral setting – around 2.5 per cent.

“But this inflation isn’t caused by excessive demand, it’s mostly caused by supply shock, which means that the interest rate increases aren’t actually going to be highly effective at slowing this kind of inflation,” Grudnoff said.

Grudnoff said while he believes the increasing interest rates will have some impact on inflation, he’s not convinced it’s the best policy advice.

The Reserve Bank of Australia head office in Sydney. Credit: Dean Lewins/AAP

“I think mostly (the RBA) is justifying it by saying that actually it’s taking (interest rates) off emergency low levels, which is true,” he said.

“Interest rates were at 0.1 per cent (during the pandemic), which is the lowest they’ve ever been.

“But the other thing to remember is a lot of people, particularly during the pandemic, locked in those interest rates at low levels, so increasing them now is actually still a big increase for them.

“I’m just not convinced that it’s a particularly strong case right now to be increasing interest rates to try and combat inflation.”

RBA governor Lowe justified the rises earlier this month, saying higher interest rates will “help establish a more sustainable balance between the demand for and the supply of goods and services”.

The RBA’s balancing act

While the RBA’s monetary policy is always expected to have an impact on the economy, Grudnoff says the central bank moves step by step to not have too much of an effect.

“The problem with increasing interest rates to fight inflation is if you go too far with the interest rates, you can actually push the economy into recession,” Grudnoff said.

“And of course if the economy went back into recession, the RBA would then have to cut interest rates and then it looks terrible because basically they’ve increased the interest rates, caused a recession and then had to cut them again.

“So I think they’ll be reasonably cautious.”

It’s also a fine balancing act, with the central bank having to consider consumer sentiment.

“A lot of the economy is not just mechanical, but sentiment,” Grudnoff added.

“If people suddenly get really worried about the future and they stopped spending, then that could cause a recess by itself.

“It’s kind of this weird balancing act between taking money out of the economy via higher interest rates but at the same time, not trying to get people too depressed and worried about things that they plunge the economy into recession.”

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