Are the Reserve Bank's interest rate rises overlooking the bigger problem?

Australian interest rates rose sharply last year as the Reserve Bank of Australia (RBA) battled to stabilise the high inflation that’s threatening the nation.

In 2022, the bank lifted the cash rate by 3 percentage points over eight months. These hard-and-fast interest surges represent the RBA’s second-most aggressive monetary tightening cycle in its history, second only to when in 1994, it raised interest rates by 2.75 percentage points over five months.

With even more interest rate rises being forecast for 2023, and Australian bank accounts struggling to keep up with last year’s hikes, it’s important to take a step back and consider if raising rates is really the answer to the inflation problem, or if a bigger problem may be being overlooked. 

The inflation situation

The Consumer Price Index (CPI) is the best indicator for measuring Australia’s level of inflation. As of the December 2022 quarter, the annual CPI rose to 7.8 per cent – inflation’s highest annual increase since 1990. That’s why we’ve all been paying more for essentials like groceries, petrol and housing, while simultaneously watching our savings balances go down.

How did we get into this position? There are a variety of economic factors in play, but a lot of it comes down to supply and demand.

When demand exceeds supply, prices rise, limiting access to goods and services to people who are willing and able to pay that cost. If prices stay high enough for long enough, the idea is that supply will eventually expand to meet the demand, and/or demand will fall because of the higher price, until balance is restored.

The opposite is also true – when supply of goods exceeds demand, prices typically fall to encourage people to buy this extra stock. In time, this should lead to the excess supply being reduced and/or demand increasing to meet an equilibrium.

The RBA’s goal is for Australia to maintain an inflation rate of between 2 and 3 per cent, which would indicate that the economy is growing, while still allowing most everyday Australians to afford the goods and services they need.

Supply chain issues

The supply side of the inflation equation in Australia and abroad have been affected by the COVID-19 pandemic, the Russian invasion of Ukraine, and the increasing volatility of the climate – all factors that are outside the control of central banks like the RBA.

An Australian Bureau of Statistics survey from February 2022 found that 88 per cent of supply chain issues facing businesses were caused by domestic and international delivery delays, 80 per cent supply constraints and 75 per cent increased prices (including transport costs).

Even with many of the COVID-19 pandemic’s shocks and restrictions now behind us, supply chain disruptions have shown few signs of improvement. According to the AI Group:

• 79% of businesses reported supply chain disruptions in 2022, an increase of 13%
• The share of businesses facing significant disruptions was steady (rising from 29% to 31%)
• The share of businesses facing moderate disruptions rose by 11% to nearly half (48%)
• Very few businesses (only 9%) reported that supply chains improved in 2022

Unless solutions can be found for these and other supply problems, they may continue to put upward pressure on inflation in Australia and overseas.

Where do interest rates come in?

Because supply is influenced by a range of international political factors that are largely outside their control, central banks tend to focus more on managing the demand side of the inflation. Using their authority, they speed up or slow down the economy by adjusting various financial levers - the main one being interest rates. Hiking up interest rates works to lower inflation because it chokes off demand.

That said, increasing the national cash rate (which Australian banks use to lend each other cash to provide financial services) in the face of contracting supply may not only reduce inflation, but at the same time may reduce economic growth and increase unemployment, which contradicts the RBA’s mandate.

Unfortunately, raising interest rates doesn’t fix all the problems on the supply side of the economy. It only dampens the demand for goods and services by increasing the cost of borrowing and leaving mortgage holders with less disposable income to spend. But since this is a strategy that works, the RBA does it - in fact, if they didn’t use it, it would be irresponsible.

Perhaps, however, the RBA should have acted sooner. If they did something before inflation started rising out of control, they probably wouldn’t have been forced to go into rate-hike overdrive. They also likely wouldn’t be in the position they’re in now, where there’s a “narrow path” to a “soft landing”, the potential for mistakes is high and rising, and Australians are wary of their next move.

The bottom line

While the RBA forecast that Australia’s inflation would hit 8 per cent by the end of 2022, it only got as high as 7.8 per cent in the December 2022 quarter. But this is still a 30-year high, and well above the RBA’s target of between 2 and 3 per cent. Given the RBA’s previous strong language that it will do “whatever it takes” to lower Australia’s inflation, we’re likely to see more cash rate hikes this year.

Hiking Australia’s interest rates too hard and too fast could risk seeing the cost of living spiral out of control, pushing more Australians into mortgage defaults or forced property sales. Homeowners could not just lose not just a source of equity and wealth, but a secure place to live in the midst of a rental crisis. This could have devastating consequences, not only for Australian housing, but the nation’s economy as a whole.

Supply chain and geographical issues may perhaps be a bigger problem than the RBA is letting on, and oversimplifying the situation doesn’t help anyone. If this is the major driver of Australia’s high inflation, it might be time for the RBA to take a break from raising interest rates and instead encourage governments and businesses to focus on solving the root problems causing disrupting supply.

Compare home loans in Australia