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RBA fears interest rate hikes not enough to control inflation: 'That's going to impact people'

The problem with inflation really starts when people begin to expect high inflation.

Inflation could be higher for longer thanks to war in the Middle East, Australia’s brand new central bank boss has warned.

As bombs fell in Gaza yesterday, the new Reserve Bank (RBA) governor, Michelle Bullock, took the stage at a government conference in Sydney. It was her first question-and-answer session since taking over from Philip Lowe and barely a few minutes had passed before she began talking about the conflict between Israel and Palestine.

The war could reduce economic growth, Bullock said, but the bigger worry was whether it would also drive inflation.

Graphic showing a petrol pump with a chart showing the price of oil to represent inflation.
International conflicts have impacted Australia's inflation in the past, and now even the RBA is concerned their rate hikes may not be able to hamper rising costs. (Credit: Yahoo Australia)

“At the moment, we are … more worried about the potential inflation implications of this,” she said.

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In 2022, Russia’s invasion of Ukraine sent global inflation spiking. Oil and food prices rose in tandem, making life far more expensive for people around the world, and kicking off a round of rate hikes.

Also by Jason Murphy:

Now, Israel and Palestine have renewed hostilities at a terrifying intensity. Is this Ukraine 2.0? Not quite. An invasion of Ukraine was extremely unexpected. Unfortunately, the world is all too familiar with conflict between Israel and Palestine. The impact will hopefully be more limited. But the new shock to the economy arrives when things are already quite bad.

“We have just got shock after shock after shock,” Bullock said, adding that oil prices were likely to be higher than they would otherwise be, which was just yet more trouble on top of a pile of trouble.

“The price of petrol even prior to that had been going up,” she said. “That’s going to impact people. That’s likely to keep oil prices elevated as people are a little bit unsure.”

As the next chart shows, oil prices are more than US$90 a barrel. When Russia first invaded Ukraine, they spiked to more than $110 a barrel.

To get petrol back down to reasonable prices, an oil price of more like $65 would be nice. Not so long ago, we were headed in that direction, but now oil is rising again, and filling up the car is an expensive nightmare.

Expect the unexpected

The problem with inflation really starts when people begin to expect high inflation. That’s when it gets locked in. We don’t chafe at paying higher prices - instead we ask for higher wages to compensate. It can create a self-fulfilling prophecy of rapid price rises.

What the RBA wants to do is get inflation down before inflation expectations get too high. And they’ve been working on that. Inflation peaked at 8.4 per cent. It’s now down to 5.2 per cent. That’s some progress.

The kind of inflation the RBA focuses on is in domestic goods and services. The classic example is haircuts. You can’t export them, you can’t import them. These are the kind of goods where interest rates can actually affect the price, and where inflation expectations matter most.

As this latest conflict in the Middle East drives imported prices up, it may make people feel like the RBA’s efforts aren’t working. That would drive inflation expectations up, which would make it harder for the current level of interest rates to bring down the price of things like haircuts. So, in the end, the RBA may have to hike interest rates even more to lower inflation expectations and kill inflation.

“Typically, when we think about shocks to supply, you think that’s probably OK. It will wash out,” Bullock said.

“But the more that keeps inflation elevated, even if it’s from supply shocks, the more people adjust their thinking, and the more people adjust their inflation expectations.”

As the next chart shows, inflation expectations for two years’ time remain at high levels - more than 5 per cent - and they ticked up in the most recent data. The data covers the week starting October 8 - after Hamas attacked Israel - but does not cover the full retaliation.

A chart showing Australia's inflation expectations.
(Source: ANZ Roy Morgan)

Inflation expectations have, happily, slid from their peak. You can discern a slowdown trend since mid-2022. But if they rise up again, it increases the chance the RBA will raise rates.

Another rate hike is now a real chance. Before the Israel-Palestine conflict kicked off again, the market was unsure about rate hikes and had a rate cut priced in for late 2024. Now, a rate hike by March 2024 has been priced in.

There are many reasons to hope for a cessation of violence in the Middle East, and Australian inflation isn’t even in the top 100. The whole world will be better off if peace can be found.

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Yahoo Australia