Reserve Bank (RBA) governor Philip Lowe has indicated that the central bank will consider a range of options in its upcoming decisions, including larger rate hikes and leaving rates unchanged.
In a much-anticipated speech at CEDA’s annual dinner on Tuesday, Dr Lowe reiterated that the RBA is not on a “pre-set path” but noted that further rate increases are to be expected as it pursues price stability and full employment.
“We have not ruled out returning to 50 basis point increases if that is necessary. Nor have we ruled out keeping rates unchanged for a time as we assess the state of the economy and the outlook for inflation,” he said.
“The board’s priority is to return inflation to target over time. It is resolute in its determination to make sure that this current period of high inflation is only temporary.”
Dr Lowe stated that the RBA will pay close attention to developments in the global economy, household spending, and wage and price-setting behaviour as it makes its future decisions.
“Developments in each of these three areas will affect the pace at which inflation returns to target and whether the economy can remain on an even keel over the next couple of years. So, we will be watching these issues carefully over the months ahead,” he said.
With headline inflation reaching 7.3 per cent in the September quarter and forecast to peak at around 8 per cent by the end of 2022, Dr Lowe said that inflation had come as “quite a shock” recently with levels as high as 7 or 8 per cent thought to be “consigned to the history books”.
After peaking at the end of the year, the RBA currently expects that inflation will gradually decline over the next two years to sit slightly above 3 per cent by the end of 2024.
According to Dr Lowe, this fall is expected due to a number of factors including the end of COVID-19 disruptions to supply, stabilising commodity prices, and higher interest rates globally leading to slower growth in aggregate demand, less pressure on capacity and lower inflation.
“As always, there is uncertainty around this outlook. We can’t rule out further bad news abroad that throws us off this path. And domestically, we need to avoid a price-wage spiral,” he added.
“To date, while wage growth in parts of the private sector has picked up materially, aggregate wage outcomes in Australia have been consistent with a return of inflation to target. In contrast, a number of other advanced economies are experiencing much faster rates of wage growth. So this is an area we are watching carefully.”
Over the past three decades, Dr Lowe noted that most central banks worldwide have viewed their job of managing inflation largely through the prism of managing aggregate demand.
“If inflation was too low, it was because demand was too weak and this called for monetary stimulus. Conversely, if inflation was too high, it was because demand was too strong and this called for monetary tightening,” he explained.
“We recognised that the supply side mattered, but supply was largely treated as something that evolved fairly slowly in the background. The task was to manage aggregate demand with interest rates.”
However, the central bank governor stated that the supply side is now looking more challenging and will likely play a more prominent role in inflation outcomes moving forward.
In addition to the recent pandemic disruptions and Russia’s invasion of Ukraine, Dr Lowe pointed to longer-term developments that may lead to more variability in inflation than experienced previously including the reversal of globalisation, shifting demographics, climate change and the energy transition in the global economy.
“All four of these supply-side developments are first-order issues that are likely to affect the environment for Australian business over the years ahead,” he said.
“They are also likely to affect the inflation dynamic here and elsewhere, leading to more variability in inflation from year to year.”
Amid this variability in inflation, Dr Lowe said that it would be increasingly problematic to set a narrow range in which inflation is meant to remain within and suggested that a strong nominal anchor would be “more important than ever”.
Furthermore, he said that another implication of variable inflation is that the monetary policy environment is likely to be more challenging for central banks.
“In a world in which central banks are managing fluctuations in aggregate demand with a relatively flat supply curve, the monetary response to demand shocks is relatively straightforward,” said Dr Lowe.
“Life is more complicated in a world of supply shocks; an adverse supply shock increases inflation and reduces output and employment. Higher inflation calls for higher interest rates but lower output, and fewer jobs call for lower interest rates. It is likely that we will have to deal with this tension more frequently in the future.”
Jon Bragg is a journalist for Momentum Media's Investor Daily, nestegg and ifa. He enjoys writing about a wide variety of financial topics and issues and exploring the many implications they have on all aspects of life.