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Interest rates, inflation and the risk of recession

A composite image of RBA governor Philip Lowe and Australian cash notes amid recession fears.
The RBA's tardiness in hiking rates may lead to a period of protracted inflation rather than a recession.

As things stand, the current 0.85 per cent official cash rate set by the Reserve Bank of Australia (RBA) is ridiculously low given the outlook for inflation, wages and the unemployment rate.

As RBA governor Philip Lowe has hinted on several occasions, for the cash rate to start constraining inflation pressures - which are at their most extreme in 30 years - it needs to be above 2.5 per cent, perhaps by a considerable margin.

It is currently 165 basis points below that level.

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This is why the sensible economists are looking for the RBA to hike the cash rate to 3 per cent, or a touch more, before they can be confident about annual inflation coming back to the 2-3 per cent target band that has serviced the RBA so well for three decades.

In other words, if the RBA is fair dinkum about getting interest rates to a level that will help contain inflation from the current extreme levels, it should be working as quickly as possible to get official interest rates to neutral and then to a slightly restrictive level.

This means getting rates to 2.5 per cent and more as soon as possible.

It is certain that underlying inflation will be hovering around 4 per cent for the next year, even with more interest rate increases in the months ahead.

Wages growth is lifting solidly, which will be supportive for household spending - a point that will be assisted by the near certainty that the unemployment rate will be holding below 4 per cent for another year or more.

This 50-year low for unemployment shows the labour market to be stronger than the ‘full employment’ level for the Australian economy.

The RBA meets on July 5

At its meeting in July, the RBA would be wise to hike by 75 basis points, to get the cash rate to 1.60 per cent.

It could then follow up with a number of 50-basis-point moves over the subsequent few months to ensure monetary policy is working to get inflation under control as soon as possible.

It is the best, more efficient way to get cost-of-living pressures under control.

Dithering around with smaller interest rate hikes will only delay getting inflation back to acceptable levels.

This is all the more important given how slow the RBA was to even start the rate-hiking cycle. Sometimes economic policy urgency is needed and now, with inflation surging and the labour market in over-full employment, is one of those times.

Are we heading for recession?

With the economy poised to slow, there is a cottage industry developing on who can forecast a recession.

While no economic outcome can be ruled out, the tardiness of the rate-hiking cycle suggests there is a greater risk of a protracted inflation boom than there is a recession.

Household finances are in strong shape, with rising incomes and high savings; businesses are investing at a rapid pace and bottom line GDP growth is forecast to hold around 2.5 to 3 per cent for the remainder of 2022 and into 2023.

And while the upcoming Budget in October, from the new Albanese Government, is likely to be less stimulatory than the policy settings from the Morrison government, several state governments have ramped up their spending to ensure government demand remains firm over the next 12-18 months.

The chance of a recession in these circumstances is remarkably low. Indeed, there will more likely be a period of strong growth, continued low unemployment and buoyant growth in wages – the exact opposite of a recession.

For now, the case for further interest rate hikes remains indisputable. It is now just a case of magnitude and timing of those hikes, as the RBA meets each month between now and year’s end.

Official interest rates need to get to around 2.75 per cent by the end of the year if the RBA is to build its inflation-targeting credentials, which means approximately 200 basis points of hikes in six months.

Going 75 basis points in July would mean it could then ease back and implement smaller hikes in the months following as it gets closer to its ultimate aim of having monetary policy settings at a mildly restrictive stance.

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