Yahoo Lifestyle RBA has gone too far and nervous nellies should admit it as interest rises don't impact these crushing costs
'Unneeded' interest rate hikes are being floated, but there are many burdensome costs they have no impact on, and that's why they are problematic.
Of course, monetary policy works. Rising and high-interest rates have the objective of crushing the economy, forcing householders, small businesses and large corporations to cut their spending, investment and staffing plans.
This economic hardship forces householders and firms to scale back the extent of wage claims and price increases as demand for their labour, goods and services subsides. This, with a lag, means lower inflation.
But like all medicine to correct an illness, in this case, the illness is inflation being too high, there can be an overdose which leads to unpleasant and unnecessary side effects.
The Australian economy is in this territory and the Reserve Bank of Australia (RBA) knows it.
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The RBA approach to lift interest rates from the 0.1 per cent low point starting in May 2022 was correct as the pandemic came to an end and inflation took off.
While it was slow to recognise the problem with its rate hikes being late and timid, it caught up to what was needed and arguably, given the recent economic growth momentum, may have gone too far.
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Annual GDP growth is set to fall below 1.5 per cent which is -1 per cent in per capita terms.
Further interest rate hikes, as is being speculated at the moment, would create consequences for the rest of the economy that are undesirable and unneeded.
Interest rates work, but they don’t fix everything
It is important to remember that the prices of a key set of goods and services that feed into the inflation rate are not impacted by interest rates.
This is a vital issue when it comes to interest rate settings.
By way of example, interest rates could be say 10 times current levels and would have very little, if any, effect on the price of tobacco, petrol, food prices influenced by weather events (recall recent examples of bananas and lettuces), the excise indexation effect on beer and wine, child care, part of health care, postage and public transport fares.
There are other items where the effect of interest rates on prices is problematic.
And this is whether prices of these items are jumping or slumping.
The RBA tries to overcome these obvious difficulties by using a trimmed measure for inflation.
This approach takes out the items with large or outsized rises or falls from quarter to quarter, but that may be an error if those gains are due to excessive demand rather than a tax change, an exogenous effect or weather impacting food prices.
Research from the RBA shows that these trimmed-mean estimates can be affected by the presence of expenditure items with very large weights in the CPI basket and as a result can be misleading.
There is a case that the RBA broadens its analysis of inflation momentum relative to the target. Trimming the importance of items that are not impacted by Australian interest rates would be a start.
After all, interest rate hikes from the RBA will have approximately zero effect on global oil prices.
This is even if rate hikes force an Australian recession that sees local demand for oil fall. So too with tobacco, where the price is largely the result of government policy to improve health outcomes for Australians, rather than prices being driven by excessive demand.
It is fanciful to think that interest rates should be influenced in any way by changes in these sorts of items.
While the RBA says that it often ‘looks through’ these types of price changes when it comes to setting interest rates, it is ad hoc and imprecise.
Estimating the price changes of a basket of goods and services that are sensitive to monetary policy, rather than what consumers spend their money on, would help in not having ‘overkill’ in interest rate settings.
Accept we don't have control over all inflationary pressure
Last week’s March quarter inflation data confirmed an unambiguous slowing in the inflation rate, but there are some nervous nellies who think the fall is not happening as rapidly as they would like.
At one level, with the economy squarely in a per capita recession after a stunning 425 basis points of interest rate hikes in the last two years, inflation should be lower. And maybe the interest rate sensitive part of the inflation rate is.
The current hawkishness ignores the impact on the headline inflation rate of those items which the RBA has little or no effect on.
In that context, with overall headline annual inflation at 3.6 per cent, consider these driving factors for annual price changes:
Lamb down 16.8 per cent (weather-related)
Fruit and vegetables down 0.2 per cent (weather-related)
Bread up 8.3 per cent (global conflict supply related)
Tobacco up 11.3 per cent (tax-related)
Beer up 6.3 per cent (largely tax)
Petrol up 5.2 per cent (international conflict)
Postal services up 15.4 per cent (Australia Post recouping losses)
Insurance was up 16.4 per cent (weather-related).
A quick calculation suggests that taking these items out of the headline inflation rate, the so-called ‘interest rate driven inflation rate’ is around 2.9 per cent, within the RBA target.
A lot of judgment will be required to determine what items should be excluded from the CPI basket to determine the interest rate-driven inflation rate.
This could change from year to year depending on tax changes, weather, global events and other exogenous factors.
In the past, the RBA did use a measure that has this goal for the appropriate measure of inflation for interest rate settings.
The Treasury's underlying inflation rate excluded a fixed range of items.
It was a high-profile inflation measure for the RBA from the mid to late 1990s but was abandoned when the trimmed and weighted mean measures moved towards the policy focus of the RBA.
