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OPINION: Interest rate hikes – the upswing begins

·3-min read
RBA governor Philip Lowe
The RBA lifted the cash rate 0.25 percentage points to 0.35 per cent on Tuesday. (Source: Reuters)

Finally!

The Reserve Bank of Australia has responded to the surge in inflation with the start of what is likely to be a sharp tightening of monetary policy.

That means today’s 0.25 basis point increase in the cash rate to 0.35 per cent is the first baby step in what will be a long march towards getting official interest rates to 3 per cent or so by the middle to end of 2023.

This is the magnitude of interest rate changes that will be needed to bring the underlying inflation rate from a likely peak of around 4.5 per cent in the second half of 2022, back to the middle of the 2 to 3 per cent target band, hopefully in late 2023 or 2024.

Also by Stephen Koukoulas:

In lifting the cash rate today, RBA Governor Philip Lowe noted that inflation was materially higher and more entrenched than he was expecting as recently as last month.

He also said wages pressures were unambiguously building as the unemployment rate cascaded towards a 50 year low.

To give Lowe some credit, in acknowledging the above changes, he was alert to the errors he and his Board made in the early part of 2022 when it left interest rates at 0.1 per cent despite the obvious overheating in the economy.

It is now clear that each monthly meeting of the RBA board will see further interest rate hikes delivered. The questions will be whether the moves are in 25 basis point increments and whether there will be a case for a 50 basis point move or two.

If inflation keeps rising and labour cost surge, a few 50 basis point hikes would be appropriate.

Tough love

Sometimes the right stance on economic policy is to divert household and business spending away from consumption and investment rather than having policies that boost economic activity.

Strong economic growth, like good red wine, can lead to problems if you have too much of it.

When an economy is registering uncomfortably and unsustainably high inflation, as now with inflation at a multi-decade high, policy-makers will need to rein in spending so that inflation comes back under control and settles within the inflation target.

The budget in March was also an example of wrong policy. By pumping money into people’s pockets via cash handouts and the temporary cut in petrol excise, this will boost inflation and make cost-of-living pressures worse as businesses raise their selling prices.

The extra cash from the budget will go straight into spending and allow firms to hike their selling prices because demand is so strong. It is actually adding fuel to an already difficult inflation and cost of living period.

Less cash will see businesses less able to hike prices which, by definition, is how inflation is brought back under control.

And so it is with the RBA and interest rate hikes.

They work!

The long run good health of the economy requires economic policy to be easy when the going gets tough, and to reverse that with tighter policy when things improve. Australia is at that latter stage now.

Now that monetary policy is moving in the right direction with the start of a tightening cycle, after the election on 21 May, whichever side wins, will need to revisit the current sloppy budget settings and look to trim spending and tweak taxes to firstly take some heat off inflation, but also to start to repair the budget that is on track to have another decade of deficits and over $1.2 trillion of debt.

It won’t be easy, but like the lift in interest rates, it must be done.

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