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Booming economy means interest rates have to keep climbing

·3-min read
Composite image of a foreman standing next to shipping containers, and Australian money, economy.
Australia's overheating economy is helping to drive inflation. (Source: Getty)

Next week is a big one for the economy.

The RBA meets and the only issue for heated discussion will be the size of the interest rate hike.

Next week also sees the release of June-quarter GDP data, which will confirm the economy is ripping along at a strong pace.

Also by the Kouk:

Let’s look at the GDP result first.

Annual growth in the economy is likely to be around 3.25 per cent, a pace that is well above the speed limit for growth - seen to be around 2.75 per cent.

It doesn’t sound like a big difference but half a per cent extra GDP growth leads to hot demand for workers and an ability of firms to increase their selling prices - inflation in other words.

The economic growth data should knock on the head the largely misguided calls that the current inflation problem is mainly a supply chain issue.

While there is clearly an element of this in some parts of the economy, demand growth is allowing for these supply-driven costs - and a range of others to be passed on - hence the inflation surge.

As the Reserve Bank (RBA) and Treasury have noted, the pace of growth has to slow for inflation to gradually return to the 2-3 per cent band.

It does look as though that softness is probably unfolding and, by this time next year, GDP growth will be 2 per cent and it could well dip a little below that in late 2023.

This would be good news because it would signal the economy moving on to a more sustainable growth path than was recorded in the first half of 2022.

So, what about interest rates?

The RBA has lifted official interest rates by 175 basis points so far in the current cycle, with the cash rate currently at 1.85 per cent.

Despite the hikes, it is a ridiculously low interest rate given the pace of economic growth, inflation and the quite staggering boom in the labour market, where the unemployment rate is 3.4 per cent and advertised salaries are, according to Seek, up more than 4 per cent in the past year.

The RBA remains well behind the curve when it comes to the level of interest rates.

A 75-basis-point hike next week would be the best policy option but, given the timidity of its policy decisions to date, it is more likely to opt for a smaller move.

A 50-basis-point hike would take the cash rate to 2.35 per cent which would help in the task of containing inflation.

While there is some evidence the economy is starting to slow a little, the extent of the slowdown is, at this stage, marginal.

Earlier this week saw news of rampant growth in retail spending into July.

Business investment plans remain very upbeat.

These are a couple of dominant reasons why the market is pricing in a peak cash rate around 4 per cent which, if achieved, would see more than a doubling of the current cash rate.

While the inflation problem and economic overheating issues are still acute, it remains unlikely that such a cash rate peak will be needed into 2023 to get growth and inflation lower.

The signs from the global economy for lower inflation are encouraging. Commodity prices are down from their peak in June, growth is lower and supply issues are rapidly being resolved.

An official cash rate of 3 per cent or so should be enough to engineer a growth slowdown and, with that, a moderation in inflation.

Before then, get set for a further rate hike from the RBA next week, with the simple rationale for the rise being the fact the economy is still too strong and that some further withdrawal of economic stimulus is needed.

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