It would be irresponsible for the RBA to ‘Let Inflation Run’

I’ve seen an increasing number of articles and commentary in recent days arguing that the RBA needs to slow down with interest rate rises or risk ‘making a huge mistake’ and triggering a recession. The argument generally goes, “our current inflation woes are all caused by international supply problems and rate rises won’t do anything to help, so the RBA should just stop raising rates”.?

This whole idea is both wrong and irresponsible for a whole range of reasons, let’s go through the big ones.?

First, our current inflation is not only supply-driven, supply issues certainly kicked it off, but we now are definitely seeing significant demand-driven inflation (for example underlying inflation in the June quarter was 4.9%). Wage growth is also heating up, and I expect that with real wages falling rapidly and unemployment very low, employees will be seeking to play catch up over the next year, pushing wages higher. We are also nowhere near peak inflation, with Treasury predicting peak inflation won’t arrive until the end of this year somewhere north of 7.75%.

Second, inflation has a devastating impact on individuals and the fabric of society. It erodes people's savings and wages and eats away at people’s quality of life, and the longer inflation goes on, the worse these impacts are. Inflation also has a tendency to become entrenched. People and businesses start expecting prices to rise and pre-empt those increases by increasing prices or pursuing higher wages. While the impact from a potential recession is not great, they are usually short and have minimal long-term impact on an economy. On the flip side, entrenched inflation is much more damaging to an economy, and can require devastating long-term adjustments to tame. Just look at the devastation of the 1970s or the disaster currently unfolding in Turkey. A short recession if the RBA overshoots on rate rises a bad, but it's a much better outcome than letting inflation become entrenched.

Third, the cost of raining in inflation gets higher the longer and more entrenched inflation gets. The rate rises and demand destruction required to reduce inflation from 6% are exponentially less than if inflation is at say 10%. By pushing up rates and taking aggressive steps now, the RBA is taking the low-risk approach. If they pause and wait, and inflation runs away again, it will require a considerably higher peak interest rate and higher rates for longer to bring inflation back down.?

Finally, there are some important, but less central reasons that the RBA should be raising rates:

• First, the RBA needs to start de-risking the economy. Low rates and initiatives like Quantitative Easing and the Term Funding Facility flood the lending market with almost free money. This pushes down yields on less risky investments (like bonds) and forces lenders out along the yield curve to find returns. Lenders are forces to write more risky loans in pursuit of yield. As a result, some of this lending will be terrible and the RBA needs to gradually weed that bad lending out of the system, reducing systematic risk across the whole economy.?
• Second, the RBA need to get rates back to a reasonable level, so they have some ammunition the next time they have to stimulate the economy. A neutral level for interest rates in Australia, if inflation is within the RBA’s target band, is likely to be around 2.5% to 3.0% (a real rate that is very slightly positive). We need rates to get back up to this range so that we both have non-stimulative rates at target inflation and the RBA has the captaincy to cut rates in the next crisis.?
• Third, the RBA needs to continue to increase rates to protect the dollar. With other major economies, and in particular the USA, increasing rates, the AUD will fall under further pressure if the RBA does not keep up. The AUD has been supported over the last 12 months by demand from China for our resource exports and near record high resource prices. However, the Chinese economy is slowing down and so the AUS will need more support from the RBA. Letting the AUD fall is not an option, that will lead to even more imported inflation and just make our current problems worse.