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The governor of the central bank discussed the reasoning behind the decision to hold the cash rate during a speech today (8 August). The main reasoning was to keep inflation steady.
“The mandate of the Reserve Bank Board is to contribute to the economic prosperity and welfare of the Australian people by delivering price stability and full employment. In practice, this means setting monetary policy to keep inflation between 2 and 3 per cent and employment at the maximum level that is consistent with maintaining low and stable inflation,” said Bullock.
“We achieve this by setting the interest rate on overnight loans between banks (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation.”
Striking a balance between inflation and unemployment was the desired outcome of holding the cash rate, said Bullock.
“That sounds straightforward. But it is quite complex. It involves the Board assessing current economic conditions, forecasting how the economy is likely to evolve over the coming year or so, considering the risks and trade-offs and then deciding what level of interest rates is required to deliver an inflation rate of between 2 and 3 per cent, while at the same time keeping the unemployment rate as low as possible. The experience since the pandemic has demonstrated just how complex this can be,” she said.
“Since the pandemic, there has been a worldwide surge in inflation. Initially it was driven by disruptions to supply chains. Resurgent demand coincided with difficulties getting goods produced and distributed around the world, which led to large price rises. Then, when Russia invaded Ukraine, there was a second shock as energy prices rose dramatically. As with other countries, Australia felt the impacts of these shocks. We saw inflation rise sharply, peaking at 7.8 per cent at the end of 2022. We hadn’t seen inflation this high in more than 30 years.
“But higher inflation wasn’t all due to supply shocks. There was also a surge in demand as countries came out of the pandemic and people were keen to spend on goods and activities that were restricted during lockdowns. So central banks around the world increased interest rates sharply – first to remove the stimulus from very low interest rates and then to move them into restrictive territory where they would start to restrain demand.”
Considering the current cash rate of 4.35 per cent is at a 12-year high, many are displeased at the decision to remain steady. However, there hasn’t been a rise since April 2022, where it climbed 0.1 per cent.
“Australia too has seen a sharp rise in interest rates. The cash rate has risen from 0.1 per cent in April 2022 to 4.35 per cent today. The most obvious area where this has had an impact is on the interest rates paid by households with mortgages. It has increased their payments, which in turn has reduced the amount of spare cash they have to spend on other goods and services,” Bullock said.
“In this way, it has lowered demand. But it has also led to an increase in interest rates on deposits, which has been beneficial for those who have savings. These cash flow effects, though, are just one way in which monetary policy works through the economy. Higher interest rates also reduce incentives to borrow, lower the demand by firms to invest, support the exchange rate, and by themselves weigh on asset prices and hence wealth. All these effects lead to lower growth of demand in the economy, thereby helping to bring it back into better balance with supply.”
Noting that inflation is “still too high,” the RBA is reportedly working to reduce the impact on Aussie consumers. Despite this, the process is “proving very sticky”, said Bullock, and the board doesn’t expect inflation to be back to 2–3 per cent until the end of 2025.
“Demand for goods and services in the economy is still higher than the ability of the economy to supply those goods and services. A key point to make here is that demand recovered very strongly after the pandemic, to quite a high level. So even though demand growth has been fairly weak recently, this slowing has not been enough to restore balance in the economy. The board has been trying to bring inflation down by slowing the growth of demand to bring it back into line with supply. And it has been trying to do this while preserving as many of the gains in the labour market as possible. We’ve described this as the ‘narrow path’,” she said.
“At its meeting on Tuesday, the Board noted two things. First, that although growth in the economy has been weak, estimates suggest that the gap between aggregate demand and aggregate supply in the economy is larger than previously thought and this is resulting in persistent inflation. It also noted that the growth of demand looks like it will pick up over the next year, although there is considerable uncertainty around the outlook. The effect of this is that the Board’s expectations for when inflation will come back to target have been pushed out.
“We don’t expect to be back in the 2–3 per cent target range until the end of 2025 – over a year away. This is why the Board explicitly considered whether another interest rate rise was required to ensure inflation continues to decline in a reasonable time frame. On balance, the Board decided to keep interest rates on hold, judging that such an outcome would still meet the Board’s mandate to balance its inflation and employment objectives. But the Board remains vigilant with respect to upside risks on inflation and will not hesitate to raise rates if it needs to. I know this is not what people want to hear. But the alternative of persistently high inflation is worse. It hurts everyone.”
[Related: RBA holds; inflation path has been ‘slow and bumpy’]
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