Inflation and Monetary Policy | Speeches

I would like to thank AMCHAM for the invitation to speak today. It is a pleasure to be here.

It is a challenging time in the global economy. Most countries, including the United States and Australia,
are experiencing the highest rates of inflation for many years. The tragic events in Ukraine have led to
sharp increases in the prices of food and energy. And interest rates are rising around the world from the
record lows during the pandemic. All this is happening at a time when unemployment rates are as low as
they have been for many decades and household budgets are under pressure. So, it is a complex policy
environment.

Today, I would like to begin by focusing on the recent inflation data and the outlook for inflation. I
will then turn to how monetary policy is responding to the higher inflation. I would also like to share
with you some of the observations from the Reserve Bank Board’s review of the yield target, which was
published earlier this morning. This review is one element of a broader set of reviews the Board is
undertaking of our pandemic response. We want to be transparent and open, and to learn lessons for the
future.

Inflation

First to inflation.

The rise in inflation is a global story – it is occurring everywhere (Graph 1). In the United
States and Europe, inflation is above 8 per cent and the peak has not yet been reached in some
countries. Inflation has also picked up across Asia, although it is lower there than in the North
Atlantic. Japan is a notable standout; while inflation in Japan has picked up, it is only just above
2 per cent.

Australia is no exception to the general trend, although inflation here remains below that of most other
advanced economies. In headline terms, inflation in Australia was 5.1 per cent over the year to
the March quarter, which is the highest rate in many years (Graph 2). In underlying terms, the
inflation rate was 3.7 per cent, which is higher than it has been in recent years, but still
lower than it was during the resources boom. In both headline and underlying terms, inflation is much
higher than we had earlier expected.

The fact that inflation is higher everywhere tells us that there are powerful global factors at work.
During the pandemic, supply chains were interrupted around the world, delivery times were pushed out and
firms’ costs of production rose. The inevitable result has been higher prices. And on top of this,
Russia’s invasion of Ukraine has caused major disruptions to the global markets for energy and food.
As a result, oil prices have increased by 28 per cent since February and global food prices,
including the prices of wheat and vegetable oils, have increased sharply (Graph 3). There has also
been strong growth in demand globally, supported by stimulatory fiscal and monetary policy around the
world.

When major events like these occur, it simply isn’t possible to insulate ourselves here in Australia
from their effects. We live in an interconnected world and big shocks in global markets affect our
domestic markets and the prices that we pay. 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
(Graph 4). 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. 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 labour market, with many firms reporting that the
availability of labour is a significant constraint on their ability to operate and/or expand
(Graph 5). 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 annualised price increases of more
than 3 per cent is at the highest level since 1990 (Graph 6).

When the RBA published its latest set of forecasts in early May, we expected that inflation would peak at
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, petrol 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 at 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 from
last year, the prices of semiconductors have declined from their recent peak and the global production of
cars is showing signs of a recovery (Graph 7). 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 current 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 underway 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 current inflationary pressures.

Monetary Policy

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 (Graph 8). These were
the first increases in the cash rate since 2010.

The Board judged that, given the inflation data and outlook that I have just discussed, it was no longer
appropriate for interest rates in Australia to remain at the COVID-emergency levels. The increase in the
cash rate in May followed the higher-than-expected CPI outcome in the March quarter and evidence from
business surveys and our own liaison that growth in labour costs had picked up and would continue to do
so in the months ahead. In June, we decided to make a bigger, 50 basis points, adjustment on the
basis of the additional information suggesting a further upward revision to an already high inflation
forecast. The Board also gave consideration to the fact that the level of interest rates was still very
low.

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 at 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 that is experiencing high inflation. I want to emphasise 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 labour market.

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

The recent news on household spending has been broadly positive, with spending bouncing back following the
Omicron setback. 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.

The Yield Target

I would now like to shift gear and turn to the review of the yield target, which the RBA released earlier
this morning.

First, some background. As part of its pandemic response in March 2020, the RBA implemented a target for
the yield on three-year Australian Government bonds. At the time, the target was 25 basis points.
This target was part of a comprehensive package designed to lower funding costs in Australia and support
the supply of credit. The Board chose to directly target the yield on three-year government bonds, rather
than implement a program of bond purchases. It judged that, in the circumstances of the time, this was a
more direct way of influencing the interest rates that matter most to the cost of finance in Australia.

The target was lowered from 25 basis points to 10 basis points in November 2020 and was
discontinued a year later, in November 2021. For most of the time the target was in operation, the RBA
did not need to buy bonds to achieve the target, although there were a few episodes when we entered the
market to keep the three-year yield consistent with the target (Graph 9). All up, the RBA purchased
around $36 billion of three-year bonds in support of the target.

The review published this morning discusses the main decision points and lessons from this experience.

It concludes that the yield target was successful in lowering funding costs and supporting credit
provision. In doing this, it helped the economy recover from the pandemic. But these benefits came with
complications. If similar circumstances were to arise in the future, the Board would likely make
different choices, although it has not ruled out using a yield target again in some form.

Given the yield target was part of a policy package, it is difficult to disentangle its specific
contribution to the declines in the interest rates faced by households and businesses. But following the
introduction of the target, lending rates fell considerably, especially fixed rates. Indeed, banks
lowered the interest rates for their three-year fixed-rate loans to be well below the new variable rate
for the first time and the fixed-rate share of new housing lending rose to new highs (Graph 10).
This helped support the housing market and household finances during the pandemic.

One particular feature of the yield target that the review draws attention to is that it was construed as
a form of time-based guidance. This interpretation was reinforced by the Bank’s communication that,
in the central scenario, policy interest rates were unlikely to be increased until 2024. This time-based
element of our communication was helpful in the dark days of the pandemic, sending a strong message that
the RBA would provide the support that was needed. But the yield target was not a flexible policy
instrument as times changed. It also created a communication challenge given that the Board’s
decisions were, in fact, dependent upon the state of the economy, not the calendar.

As the health situation improved and the economy turned out much better than expected, the yield target
became a less effective policy. Other market interest rates for similar terms moved away from the yield
on three-year government bonds, limiting the transmission of the target to the real economy. This was in
contrast to the first phase of the pandemic, when the target was closely aligned with market interest
rates.

The review also draws attention to the fact that the Board maintained a very strong focus in its
decision-making on insuring against downside risks. At the time the target was adopted, there were
credible forecasts that tens of thousands of Australians would die, the demand for hospital beds would
exceed capacity and a vaccine would be years away. The unemployment rate was expected to reach
double-digit levels and there were fears that there would be deep economic scarring and a generation of
Australians would face lost opportunity.

In this environment, the Board was very concerned about downside risks to the economy. It sought to
provide insurance against these potentially very bad outcomes, and the yield target was part of this. It
certainly recognised that things could turn out better than expected, but its priority was guarding
against the downside. This was on the basis that if the downside did prevail, the costs to our society
and our economy would be very high and there would be little further scope for the Bank to respond. On
the other hand, if the worst outcomes were avoided and the upside prevailed, the policy could be
adjusted, as it ultimately was.

The review discusses various decision points and the different decisions that could have been made at
these points. With hindsight, it can be argued that there was too much focus on the downside risks to the
economy and the need to insure against them, and too little focus on the possibility that things could
work out better than expected. But in real time, in which decisions had to be made under great
uncertainty, the review notes that the focus on the downside risks was understandable. The Board
recognises that opinions will differ as to whether it struck the right balance.

As part of its review, the Board has agreed to strengthen its scenario analysis in future decision-making.
It also recognises that the way the target ended in late 2021 was disorderly and caused some reputational
damage to the Bank. It accepts that earlier communication from the Bank could have eased the situation,
although the end of a target that was losing credibility was always likely to generate some volatility in
market prices.

The Board has not ruled out using a yield target again in extreme circumstances, but views the probability
of doing so as low. The use of a yield target in some form would need to be evaluated against other
policy options, including a bond purchase program. Such a program offers more flexibility, but it does
carry other risks. These include larger potential financial costs for the central bank and the
possibility of impaired bond market functioning as central bank bond holdings increase. There can also be
challenges in unwinding a large bond purchase program.

To assist with its future policy choices and to learn further lessons from recent experience, the Board
will undertake a review of Australia’s experience with the bond purchase program later this year. It
will also undertake a review of the Bank’s approach to forward guidance. Consistent with our
commitment to transparency and accountability, these reviews will also be published.

Thank you for listening and I am happy to answer questions.