In Australia, the RBA has engaged in a “high wire” act in exercising a comparative caution in raising the policy rate.
While recession fears continue to stalk US markets, the December quarter Consumer Price Inflation (CPI) data indicate that the Reserve Bank of Australia (RBA) has a serious inflation challenge on its hands.
Indeed, the “recession” scenario is not implausible – both in the US and here in Australia.
In Australia, the RBA has engaged in a “high wire” act in exercising a comparative caution in raising the policy rate. There is some prospect this could be more damaging than the alternative.
RBA Governor Lowe has stated that the path to returning inflation to 2-3% and keeping the economy on an even keel “is a narrow one”. The December quarter CPI might have made that path narrower.
The missteps in RBA communication, including the “no increase in the policy rate before 2024”, have been well documented. However, it is more important to recognise that the substantive error that led to that flawed policy communication was the underappreciation of the persistence, magnitude, and momentum of inflation.
Of course, the RBA was not alone in the lack of appreciation of inflation dynamics. Nearly every developed country’s central bank (and global rate markets) made a similar error. That error meant that, as central banks scrambled to catch up with the inflation reality, a slowdown in growth was unavoidable – it was “baked in the cake” as far back as late 2021.
There have been some differences between central banks on the best way to rectify their mistake and differences of view on the least costly in terms of the dislocation in employment and output.
On the one hand is the approach adopted by the US Federal Reserve, the Bank of Canada and the RBNZ of an aggressive approach to inflation containment. I would argue that recent inflation developments in the US vindicate the Fed’s approach.
Of course, recession is the big question insofar as the outlook for the US economy is concerned. The Fed’s activity projections for 2023 are not inconsistent with a recession, and in public commentary, Fed officials rate the chance as 50/50. That seems fair, even if the data has not validated that view to date.
I thought Fed Chair Powell put the case for an aggressive approach very well back in his press conference after the November Fed FOMC meeting when (channelling the 70s / early 80s experience) he said:
“…if we over tighten, then we have the ability with our tools, [then] we can support economic activity strongly if that happens if necessary. On the other hand, if you make a mistake in the other direction, and …it’s a year or two down the road, and you realise inflation is behaving the way it can…you have to go back in. By then, the risk really is that it has become entrenched in people’s thinking, and the record is that the employment costs, the cost to the people that we don’t want to hurt, they go up with the passage of time…” (my emphasis)
This brings me to the RBA’s more cautious approach. The RBA appeared to believe that while the inflation spurt was greater than anticipated, it would prove more easily containable.
That approach arguably did not reflect the lessons of both recent (post-pandemic) history and lessons of decades past (the high and persistent global inflation of the 1970s and, in Australia’s case, well into the 1980s).
For one thing, it appeared to downplay where monetary policy has come from. The pandemic saw monetary policy assume unprecedented levels of accommodation. Viewed through that lens, policy adjustments through 2022 may have represented a return to some version of normality. Perhaps (the US and one or two others aside) significantly tighter conditions are required to meet the inflation challenge, including in Australia.
Some of the RBA ‘s caution also reflected a belief in “Australian exceptionalism”: the notion that Australia’s wage and inflation circumstances are somehow less challenging than elsewhere in the developed country complex. The evidence for such “exceptionalism” is not only scant but fundamentally misplaced.
Indeed, well-intentioned but possibly flawed changes to the regulatory environment, particularly (but not solely) concerning the wage-setting framework, run the risk of entrenching higher inflation in Australia compared to elsewhere.
High-frequency data such as the NAB monthly business survey – while down a little from extremely elevated levels – continue to indicate considerable wage and price momentum into 2023.
The RBA has defended its comparative caution by warning against “scorching the earth” to get inflation down, implying a more aggressive approach involves outsized costs in terms of activity and employment.
But drawing on the ‘70s experience – and this is implicit in Fed Chair Powell’s comments highlighted above – the “scorched earth” more likely comes from central banks exhibiting excessive caution in containing inflation and then having to slam the monetary brakes later in the piece.
That is the key risk with the RBA’s comparatively cautious approach: it admits the possibility of the emergence of the sort of inflation inertia that was last experienced in the 1970s and 1980s.
I believe the RBA should be possessed of acute inflation anxiety as it approaches 2023 and that a policy rate over that implied by domestic interest rate markets before the CPI may be a more optimal path to long-term sustainable growth in activity and employment.
Stephen Miller, investment strategist at GSFM
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