The message from voters to governments in US and Australia is clear: fix the cost of living if you want to keep your job. But what can our government do about the cost of living?
Short answer: nothing that’s quick or painless. And get this: turns out that to make it better, you must first make it worse.
For a start, there’s little the government can do directly to reduce prices. In a capitalist economy the government can’t cut the prices businesses charge, nor even set limits on by how much they may be raised.
So anything it does to reduce the rate at which the cost of living is rising must be done indirectly. In the old days the government would use its budget to try to slow the rate at which prices are rising. But since the 1980s we – and all the rich economies – have left it to their central banks, which act independently of the elected government.
Like all the other central banks, our Reserve Bank sees ensuring only modest rises in the cost of living – economists would say, in the rate of inflation – as its most important duty. So what does it do when it sees prices rising too quickly? It does the only thing it can do: put up interest rates and keeps putting ’em up until it’s satisfied that prices will eventually be rising at a much slower rate.
Trouble is, all the ordinary punter sees is that they’re now having to make higher payments on their mortgage. From what they can see, the cost of living is now worse, not better. So how’s that supposed to help?
The idea is that prices rise when the demand for goods and services is growing faster than the economy’s ability to produce those goods and services. When demand for their product is growing strongly, businesses feel able to raise their prices. They may lose a few sales, but they’ll still be better off than they were.
Higher interest rates are intended to reduce demand and so slow the rate at which prices are rising. When interest rates rise, people with mortgages – and particularly younger people with really big mortgages – are left with less money to spend on other things.
As well, higher interest rates usually improve the Australian dollar’s rate of exchange for other currencies, thus making imported goods, and services such as overseas travel, cheaper. And the more money we spend on imports, the less we’re able to spend on locally produced goods and services.
Why’s that a good thing? Because it puts further pressure on local businesses to go easy on price rises. (I told you you weren’t going to like this.)
Economists have seen this process of increasing interest rates to slow the rate of price increases enough times in the past to know it works. It’s no fun and it takes a year or two to have its full effect, but it does work.
However, I can’t say I was persuaded by Reserve governor Michele Bullock’s argument that, after four rises in interest rates this year, we needed a fifth.
At 4.85 per cent, the official interest rate is now the highest it’s been in 18 years. Remember, however, that this 4.85 per cent will hurt a lot more than it did in 2008. Why? Because house prices, and thus home loans, are now much higher that they were then. About two or three times more.
Bullock said we needed a rate rise because of “excess demand” in the economy. Sorry, I can’t see it. Consumer spending accounts for well over half of total demand, and it’s not growing strongly – which you wouldn’t expect it to at a time when people are complaining so incessantly about the cost of living and retailers are describing how price-conscious shoppers have become.
It turns out the only part of the economy that’s growing strongly is business investment in plant and equipment, particularly the construction of data centres.
Really? Home buyers are being squeezed unmercifully to stop the boom in data centres? Data centres do raise questions because of their immense demand for power and water, but that’s for other parts of government to deal with.
It makes me wonder whether the management of the economy is becoming performative. Whether we’ve succumbed to government by numbers.
The government’s target is for consumer prices to rise by no more than 2 to 3 per cent a year. It’s been above that since before the Albanese government was elected in 2022. The “headline” rate of inflation is 4.3 per cent over the year to the month of September (although the more reliable measure of the “underlying” inflation rate puts it at 3.6 per cent).
The Reserve worries about its credibility when the inflation rate has been above the target for so long. The inflation target is supposed to give businesses and unions confidence that inflation will stay low and thus encourage them to act accordingly when setting wages and prices. The Reserve fears a rise in “inflation expectations”.
So it’s easy to believe that when the headline inflation rate of 4.3 per cent hit the headlines, the Reserve’s heavies decided they’d better be seen to be doing something about it.
Remember that the financial markets make their living by successfully predicting what the Reserve will do, not what it should do. So the heavies gave speeches hinting the Reserve would do more. By the time of the monetary policy board’s next meeting, the markets were almost certain rates would be raised a fifth time.
I wonder if this behaviour wasn’t intended to ensure the board agreed to another rise. In the outcome, only a third of them dissented.
With so much of the rise in our cost of living due to the high world price of petrol – about which we can do nothing – I wonder if the further tightening of interest rates will put us into recession.
Anthony Albanese has pledged to avoid a recession. Breaking news: he doesn’t get a say in the matter.
Ross Gittins is the Herald’s economics editor.
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