Why the RBA can still be patient on interest rates

The reason Lowe still has time on his side is that this week’s figures suggest that while Australia’s inflation is picking up, it is nowhere near as hot as other countries such as the US, the United Kingdom, or New Zealand. We’re also still missing out on something the RBA has been trying to engineer for years: higher wage growth.

To understand why Lowe doesn’t face the same urgency to raise interest rates as some of his peers overseas, it’s worth revisiting some central banking basics.

Monetary policy – moving interest rates – is the central bankers’ main tool for keeping inflation in the target range over the long term. But rates are an extremely “blunt instrument,” meaning they affect the entire economy, not just specific parts of it.

Therefore, central bankers often say they can “look through” inflation that they believe to be temporary.

Last year, that was the argument we heard from Lowe. As inflation pressures were building overseas, the RBA’s view was that the price rises were mainly temporary and the result of shortages of goods, which would be worked out over time.

Loading

But in recent months, it’s become clear that price rises overseas are more than temporary – especially in the US, where inflation is now near a 40-year high of 7 per cent a year.

Australia’s inflation rate is half of that, but this week’s data showed broad-based price rises including in fuel, food, clothing and footwear, domestic holidays, and transport.

The critical question is whether these price rises are a one-off, or something more fundamental that will be sustained.

Most market economists say it’s no longer credible to dismiss the inflation as “transitory.” But after so many years of missing the inflation target, Lowe has also stressed that he won’t raise rates until the inflation is “sustainable.”

Have we reached that level yet? Probably not.

It was notable, for example, that the consumer price index showed goods prices rising at 4.3 per cent, far higher than the 2.3 per cent rise in the price of services. That’s important because goods prices have been under the most pressure lately due to the disruption in global supply chains. The big price rises in some imported goods could well slow down in months to come, as supply chains recover.

By later this year, it’s possible we’ll be at the point where pay packets are rising sufficiently fast to convince the RBA it’s time to start lifting rates from virtually zero. The day was always coming, but it could arrive sooner than many thought.

Rather than supply chain bottlenecks, a bigger influence on inflation (and therefore interest rates) will be what happens to wages. That is because wages have a chicken and egg relationship with inflation: as prices rise, people demand higher pay, which in turn raises costs for businesses.

Lowe has said repeatedly that for inflation to be sustainably in the RBA’s 2 to 3 per cent band, we probably need wages to be rising by about 3 per cent a year. He is trying to achieve this by keeping rates near zero, with the hope of allowing the labour market to get so tight that employers have no choice but to pay their staff more.

The latest official figures suggested Lowe still has more to do in engineering bigger pay rises. Wage growth was running at just 2.2 per cent a year in the September quarter – but of course the labour market has tightened significantly since then.

Loading

Earlier this month the ABS said unemployment fell to just 4.2 per cent in December, its lowest since 2008. Many economists think that’s approaching the level that will be needed to force employers to start dishing out bigger pay rises – as is already happening in some in-demand sectors.

So, by later this year, it’s possible we’ll be at the point where pay packets are rising sufficiently fast to convince the RBA it’s time to start lifting rates from virtually zero. The day was always coming, but it could arrive sooner than many thought.

Right now, however, there isn’t yet the evidence that wages are going up quickly enough to justify the RBA starting to raise rates to more normal levels.

Ross Gittins is on leave.

The Business Briefing newsletter delivers major stories, exclusive coverage and expert opinion. Sign up to get it every weekday morning.