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Edition 408 – Inflation Targets

The Reserve Bank of Australia (RBA) has a target bandwidth for inflation of 2-3%. That means, when inflation is low, it wants the economy to be ticking over at this rate so that it is growing moderately, that people’s personal wealth is growing moderately and that wages are growing moderately.

When inflation is high, it looks to slow things down by ratcheting up interest rates, which puts pressure on home and business borrowers, meaning they take money out of the economy by slowing down spending.

The RBA was one of the first central banks globally to adopt an inflation target and it’s been operating at this figure, seemingly, forever. It’s been well over 30 years and possibly closer to 40 since it adopted this mantra.

The issue that I have is that the RBA has been using this old assumption, in a new world, in order to increase interest rates and slow the economy down. 11 interest rate rises in a year have put considerable financial stress on home owners and business operators. 11 rate rises were done as the inflation numbers continue to remain high. Yet, at least one esteemed economist from one of the four major banks, and someone whose work I’ve admired forever, has said that a single interest rate rise can take up to 12 months to filter through the economy. If that’s the case, what does 11 do?

When Russia invaded Ukraine two years ago, that drove up the price of fuel, which contributed to inflation.

Supply chain constraints around COVID drove up costs as some businesses were able to command more for limited supply, or supply was so limited as a result of production shutdowns, there simply wasn’t enough to go around.

The ramp-up, post COVID has been slow for some industries. International travel (at least out of Australia) remains expensive as capacity is limited on some routes. Vehicle manufacturers, such as Toyota, have two year wait periods for the new generation, 300 series Landcruiser, partially driven by the availability of semi-conductors, which operate so many of the functions in a modern motor vehicle.

Through all of this, the RBA continue to lift interest rates. Yet, rising interest rates creates four major issues:

  1. It stresses households, so they cut back on spending.
  2. It stresses small and family business, so they cut back on investing for the future.
  3. It stresses business and investment borrowers, who decide that, perhaps right now, it’s not the right time to invest.
  4. It negatively impacts small and family business confidence, which contribute almost 2/3 of GDP and employ 60% of the workforce.

Perhaps the RBA should revise their target from 2-3% to 3-5%, whilst the world is experiencing the current levels of economic uncertainty. Wouldn’t that then take pressure off households, and small and family businesses, the two sectors most exposed to rising interest rates?

And whilst we’re at it, perhaps the Federal Government should appreciate that there are two ways to control the economy – fiscal policy and monetary policy. The pre-Christmas announcement as to the cutting of big infrastructure projects underprepares us for the future. Why doesn’t the Government look at what it is spending money on in terms of programmes that are running well out of control, and well ahead of inflation, and that are part of their everyday obligations, and not strike-out at the one-off investments that are so critical to the building of our nation.

This Week’s Tip

“Using old assumptions in new scenarios will never give the right answer.”