The Reserve Bank meets this week to decide if it will lift, cut or hold interest rates.

The markets are predicting a rise.

Given the surging price of fuel due to the war in the Middle East, will the RBA inflict more pain on mortgage holders? If so, why?

If the Reserve Bank’s monetary policy board follows the evidence, it won’t hike rates. But that won’t change the fact that the central bank is still under pressure to do something about inflation.

Inflation was up even before the US and Israel attacked Iran. It was up as a result of temporary issues, like travel and accommodation.

In many ways, the higher oil and gas prices are already doing what an interest rate increase would do – preventing Australians spending their money on other things. And because almost all of our fuel is imported, the money and profits flow overseas. This drop in demand will already act as a brake on the pre-invasion inflation.

In some ways, skyrocketing fuel prices take the pressure off the RBA to lift rates this week.

You might like

Opinion

Too little, too late: alarm as state pollies ‘ignore’ SA’s environment

Opinion

Letters to the Editor led by Theo Maras on separation of Orthodox church and state

But some are arguing that the higher oil and gas prices are going to flow through to the wider economy, increasing prices and inflation … and – despite the extra pressure on households – the Reserve should increase rates as a pre-emptive strike against even higher inflation.

Are they right?

You might like

Opinion

Too little, too late: alarm as state pollies ‘ignore’ SA’s environment

Opinion

Letters to the Editor led by Theo Maras on separation of Orthodox church and state

No, because this is a type of inflation that interest rates do not impact.

The increase in oil and gas prices is a supply shock. This is a one-off increase in prices caused by a one-off event – war – and the accepted response to supply shocks is to do nothing and watch as it washes through the economy.

In this instance, there’s no need to increase interest rates because the inflation will effectively fix itself.

Don’t believe me? Here is ex-RBA governor Philip Lowe explaining exactly this:

On monetary policy and supply shocks, there is very little that monetary policy can do to offset supply shocks. Sometimes you will want to respond to the higher inflation that comes from a supply shock to stop inflation expectations rising and staying high. But if that doesn’t happen, you can let the supply shocks wash through the system.

Lifting interest rates is a tool that impacts demand. If everyone is paying more on their mortgage, then they have less money to spend on other stuff. Lower demand means businesses can’t put up their prices as much.

But a supply shock doesn’t impact demand. It impacts supply.

Petrol prices are rising because of a lack of supply from the Middle East. How can increasing interest rates bring down petrol prices? They can’t.

But you might have noticed Philip Lowe’s qualifier:

“Sometimes you will want to respond to the higher inflation that comes from a supply shock to stop inflation expectations rising and staying high.”

This is the RBA’s get-out-of jail free card. It can’t justify increasing interest rates to combat the supply shock. So, instead it justifies a rate hike by saying it’s fighting inflationary expectations.

If workers think that inflation is going to be higher in the future, they will demand higher wages now. Otherwise, they won’t be able to buy as much stuff in the future. If they get those higher wages, businesses will increase their prices to cover the increased costs of production from higher wages. And so, regardless of what might have happened, expectations about higher inflation actually caused higher inflation. It’s a vicious cycle.

But right now, workers are struggling to get a pay rise. Australia Institute research shows that wages are not driving inflation. And, given the power imbalance between workers and businesses, they are not going to be able to rapidly command increased wages in the foreseeable future.

But these inflationary expectations give the RBA an out. It can increase rates and not be blamed for misunderstanding economics.
Instead, they will say that it shows the Reserve Bank is determined to get inflation down and people will understand that determination and think that inflation will be lower in the future.

The reality is that the RBA has only one tool to fight inflation – raising interest rates.

It is considered the one institution we have that fights inflation. If inflation goes up, regardless of why, people expect the central bank to act.

And by people, I mean the markets. And by the markets, I mean rich people.

So, the RBA is under pressure to increase interest rates, even if higher rates will do little to combat inflation from higher oil and gas prices.

Will the RBA cave to this pressure and increase rates? The markets are betting they will.