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Australia has entered a new frontier in its fight against inflation after the Reserve Bank left interest rates on hold at 4.1 per cent for the second month in a row at its August meeting.
Outgoing RBA governor Philip Lowe told a parliamentary committee last week that Australia has entered a "third phase" of its battle against high inflation, which he dubbed the "calibration phase".
"We're in a world where we're just making, I hope, small adjustments to calibrate policy," he said on Friday.
But it doesn't mean we're cleared from the threat of inflation and rate cuts are on the horizon. In fact, the economy is likely to stay in this holding pattern for a while yet.
Why are interest rates on hold?
The short answer is because the RBA thinks the current cash rate of 4.1 per cent is driving inflation down at an acceptable speed.
The slightly longer answer is that the RBA wants to give the economy more time to adjust to the rate rises.
Monetary policy, or moving the cash rate up and down, takes a long time to flow through the entire economy, which is often referred to as a "lag".
The cash rate target was only 0.1 per cent in early May last year, and it has been lifted rapidly since then — 12 times across 16 months — in the steepest increase in the RBA's history, to where it's now sitting at 4.1 per cent.
After experiencing such a rapid increase in rates, the lag effect i very important.
Outgoing RBA governor Philip Lowe addressed this point last week during an economics committee hearing.
"All the evidence is that it takes time for monetary policy to fully work its way through the economy, and the first increase in interest rates was made last year, what, 15-16 months ago," he said.
"The lag is typically a year to 18 months before the full effect is felt."
In other words, the RBA is still expecting its past decisions to have an impact on inflation, so it left rates on hold in July and August to allow some economic dust to settle.
"The Board is very mindful that interest rates have been increased by a large amount in a short period of time, and ... the Board judged that the right thing to do for now was to sit and assess," Mr Lowe said.
Does this mean inflation is back to normal?
Not exactly.
To quote Mr Lowe on Friday: "Things are moving in the right direction, but it is too early to declare victory."
The latest inflation figures show annual inflation is sitting at 6 per cent, which is twice as high as the RBA would like it to be.
The RBA tries to keep inflation averaging between 2 and 3 per cent over time, because it believes that's the optimum level of inflation that will support a sustainable rate of economic growth and employment.
Given that inflation is running at an annual rate of 6 per cent, we have a way to go.
But you can see from this graph that inflation has been falling for the last six months.
And the good news is that the RBA is expecting inflation to fall even further by the end of this year.
Based on current data, the RBA estimates annual inflation will fall to 4.1 per cent by December, and will slide to 3.25 per cent by the end of next year, and reach the elusive 2-3 per cent target range by late 2025.
"I know it's been difficult, but the worst is over," Mr Lowe said on Friday.
Why is the RBA only targeting mortgage holders?
People with mortgages may feel like they're the only ones doing the heavy lifting, but interest rates play a much broader role in the economy.
Monetary policy (which is the technical term for what the RBA does when it manipulates interest rates) is understood to be a "blunt instrument" — because it affects all industries, jurisdictions and sections of the economy indiscriminately.
When the RBA changes the cash rate, it's moving a benchmark interest rate that banks and other financial institutions are charged when they borrow money.
That change then flows through to interest rates for households and businesses.
So, when the RBA lifts the cash rate as it's doing now, it's making it more expensive for those institutions to borrow money, so those institutions then pass their higher borrowing costs on to the people who borrow money from them.
In the case of our major banks, they're currently passing their higher costs onto customers with home loans and other personal loans, in the form of higher interest rates.
It also means many renters are also having to pay higher rents, in part because their landlords are facing higher interest payments from their banks.
So, it's important to note that the RBA's interest rate increases doesn't just target borrowers — higher rates also discourage spending in the economy, which reduces demand for some products and services and means the providers of those goods and services can see reduced sales, and declines in revenue and profits.
Many people also benefit from higher interest rates, too.
At the moment, some retirees are enjoying higher interest rate income from their savings, after having lived for years without getting any interest income of significance.
Why is my interest rate higher than what the RBA's is?
It comes back to the fact the RBA's cash rate is only a benchmark — and it's only part of a more complicated puzzle used by our banks in determining interest rates in the economy.
Banks are in the business of profitability, and will look at a range of factors that will allow them to offset the cost of funding loans, while maximising their revenue from providing the loans.
Those factors include:
- How much it costs the bank to fund loans
- How much competition there is in the banking sector
- The risk of borrowers not repaying their loans
These can all change over time, and so too can the interest rates the banks charge their customers.
Can the RBA do anything apart from lift interest rates to fight inflation?
The main tool available to the RBA to manage inflation is to change the cash rate.
When the RBA lifts the cash rate (which it has been doing since May 2022) it's called "contractionary" monetary policy, because it's designed to "contract" or shrink spending to slow the economy and reduce inflation.
But when the RBA cuts the cash rate (like it did during the COVID-19 recession), that's called "expansionary" monetary policy — because it encourages people to spend, which will stimulate activity and expand the economy.
Outside of its decisions on the cash rate, the RBA doesn't have many other avenues to immediately fight inflation, however it has historically targeted longer-term interest rates, by buying and selling government bonds.
Is there another way to beat inflation without lifting interest rates?
There are a number of tools that can help to fight inflation, but they aren't easy to do, and they're politically risky and slow — plus they aren't always guaranteed to work.
Some things the federal government could try to lower inflation include:
- Intervene in markets to cap or freeze prices in certain sectors
- Put a super-profits tax on particular industries and save the proceeds or use them to subsidise consumer prices
- Temporarily lift the amount employers pay in superannuation for workers in substitution for some part of wage increases
- Increase the Medicare levy or other taxes
- Pass interest increases on deposits faster, encouraging saving
- Make it easier to switch providers like banks, insurers and utilities
- Change competition laws to reduce large corporate power
- Find ways to encourage improved productivity
The first two — capping gas prices and increasing tax on industry profits — have already been implemented by the federal government.
Most of the other ideas listed above would require new laws, which could be politically painful to get across the line, and could also have unintended consequences down the line.
Trying to achieve that is also time consuming, and time is of the essence when trying to bring down inflation — and often the RBA lifting rates is a far quicker (not to mention simpler) way to tackle it.
Do we need more people to be out of work to reduce inflation?
Comments made by incoming RBA governor Michele Bullock drew ire in June, when she told a business lunch in Newcastle she expected the unemployment rate to reach 4.5 per cent (it's currently 3.5 per cent).
She explained that "while 4.5 per cent is higher than the current rate, this outcome would still leave us below where it was pre-pandemic ... [and] the economy would be closer to a sustainable balance point".
Last week, Mr Lowe also reiterated his expectation that the unemployment rate would need to rise.
"We expect employment to continue to grow, but below the rate of growth in the labour force," he said.
"As a result, the unemployment rate is forecast to rise gradually to reach around 4.5 per cent late next year."
But it's not just needing more people out of work for a reason — to the RBA, that level of unemployment relates to the Non-Accelerating Inflation Rate of Unemployment (or NAIRU).
This rate is defined as the lowest the unemployment rate can sustainably be, without causing wages and inflation to increase too much.
The theory is that if the unemployment rate is lower than the NAIRU, it puts upwards pressure on inflation because there's probably too much employment for the economy to handle, and the resulting level of wage growth and economic activity will fuel inflation.
So, it wants to find the Goldilocks level of employment — not too much, not too little — to keep everything growing at a comfortable and sustainable speed.
Is this the end of rising interest rates?
It's hard to say, because it depends on how inflation fares over coming months — and on who you ask.
The economy is still catching up with the effects of past rate rises, and both the RBA and economists are hopeful that the rate rises we've had will keep driving inflation down.
That said, the RBA hasn't ruled out future rate rises if needed.
Its August meeting minutes noted that "members agreed that it was possible that some further tightening of monetary policy might be required", but it would be dependent on economic data and other risks.
Should another rate rise be on the cards, most economists expect it won't occur until much later this year, with the current prediction around November.
At the time of writing, economists broadly expect the terminal cash rate (the highest it will go in this current cycle) will be 4.6 per cent — which suggests another two increases of 0.25 percentage points at some point.
But the economy is a moveable feast, and so is inflation and interest rates.
Only time will tell whether the RBA is satisfied it's done its job to declare long-awaited victory over inflation.
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