The RBA are trapped in a horrible inflation cycle

Now if you think I’ve been too hard on the Federal Government in blaming them for higher interest rates, the Reserve Bank is sort of backing me — in RBA-speak.

My issue is that inflation is staying higher for longer because the Federal Government has been playing the good-cop role and encouraging big wage rises. This feeds inflation, which means the RBA has to play the bad-cop by putting up interest rates which fights inflation and slows the economy… the risk is it will slow into an economic recession.

Wage rises are being based on inflation at its peak

This week’s minutes from the 6 June RBA board meeting noted “the possibility of implicit indexation of wages to past high inflation and the potential for this to become widespread. Similarly, members observed that some firms were indexing their prices, either implicitly or directly, to past inflation.”

In plain speak, they are saying a lot of wage rises are being based on inflation at its peak and not the lower level it is now (and expected to be lower over the next few months). What they are saying is that higher-based wage rises will still be there keeping inflation higher when it should be coming down faster.

But bosses are not helping inflation either. Because they are having to pay wage rises higher than inflation, they are putting up prices at a rate higher than inflation.

A horrible inflation cycle

It is turning into a horrible inflation cycle for the RBA: higher-than-inflation wage rises is leading to higher-than-inflation price rises; which is leading to inflation staying higher for longer; which means interest rates have to go up higher than expected to bring inflation down… and it looks like a recession is the only event which will make all sides see some sense.

Next week we have the crucial May CPI indicator and retail sales, which are followed the next week by housing market data – all key figures to watch before the next RBA meeting on 4 July.

The housing market is also weighing on the RBA. Because as house prices keep rising, consumers feel richer and tend to spend more rather less to bring down inflation.

The RBA minutes noted: “National housing prices had increased in recent months and households’ expectations for future rises in housing prices had strengthened. Members noted that, if sustained, this would imply less of a drag on consumption in the year ahead than had previously been envisaged.”

Interesting too was the section noting “stabilisation in housing loan approvals suggested that financial conditions may not have been as tight as they had previously judged.”

Central Banks up the ante on the fight against inflation

Last night’s 0.5 per cent increase in rates by the Bank of England surprised markets by how aggressive they were after the UK’s inflation rate looks stuck at 7 per cent.

So this week Central Banks around the world showed they are willing to keep raising rates to fight inflation:

UK: Raised rates by 0.5 per cent… more than expected, for 13th rate hike.
Switzerland: Raised rates by 0.25 per cent.
Norway: Raised rates 0.5 per cent… more than expected, for 11th rate hike.
Turkey: Historic 6.5 per cent (no I haven’t got the decimal place wrong) rate hike to 15 per cent.
US: Two more rate hikes may be needed.

Central Banks have made it very clear: inflation is still a problem.

We need to lift our rate expectations

So do we have to change our thinking? According to one of my favourite economists, and a regular on www.ausbiz.com.au, Warren Hogan, we need to lift our rate expectations.

This morning he said:

“Bank of England hikes their interest rate by 50bp to 5 per cent. This is now the third economy in Australia’s peer group to take rates to 5 per cent after NZ (5.5 per cent) and US (5.25 per cent).

“Driving the decision was a shock jump in core inflation to 7.1 per cent in May. It is looking increasingly likely that Australian rates are headed above 5 per cent given our economy is stronger than most others and our latest inflation numbers are still hovering just under 7 per cent.

“Next week’s inflation report for May will be absolutely critical for the RBA at the July meeting. It’s now a genuine 50/50 bet on a further 25bp hike in July and another in August.

“The reality is that it is looking more and more likely that Australia’s cash rate is heading above 5 per cent in 2024 as we play catch up to the rest of the world.”

Be prepared.

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