Inflation and the RBA inflation target
Background
3.1
The Reserve Bank Act 1959 outlines three broad objectives for the RBA Board in deploying monetary policy:
Stability of the currency of Australia
Maintenance of full employment in Australia
Economic welfare of the people of Australia.
3.2
Since the early 1990s, the RBA has maintained a consumer price inflation target of between 2 and 3 per cent as a means of achieving these objectives. This inflation target is the centrepiece of Australia’s monetary framework. The target is defined ‘as a medium-term average rather than as a rate (or band of rates) that must be held at all times’ and the RBA uses its monetary policy levers to achieve it.
3.3
Since the committee’s last public hearing in February 2022, Australia has experienced a surge in inflation, which has ‘very quickly gone from being too low to being too high’ and is expected to peak around 7 ¾ per cent later this year. This is in contrast to February 2022, when inflation had only just met the midpoint of the target for the first time in seven years. The Governor described the current inflation problem to the committee as ‘unwelcome’, driven by strong demand in the economy in addition to global and domestic supply challenges.
3.4
This strong demand is in part a result of the monetary and fiscal policy approaches used during the pandemic, which saw the easing of monetary conditions and considerable economic relief from government for households and businesses. Accordingly, the Governor explained to the committee, it was important to consider the original context for these policy settings:
… it can be easy to forget how dire the outlook was in 2020. There were credible predictions that the unemployment rate would reach 15 per cent, spending in the economy was collapsing, our hospitals were expected to be overflowing and a vaccine seemed to be years away. It was a scary time—a very scary time. In that environment, the Reserve Bank Board wanted to do what it could to help and to shore up confidence. We were also seeking to provide some economic insurance against the worst possible outcomes.
3.5
The committee examined the RBA’s ability to tackle inflation through the cash rate and the raising of interest rates for households and businesses—
in particular the RBA’s decision-making process, timing of rate increases, incorrect inflation forecasts, inflation psychology and expectations, and the path to bringing inflation back within the target range.
Strong medicine and tough messaging in 2022
3.6
Since April 2022, the RBA has increased the cash rate from 0.1 to 2.85 per cent. At the public hearing in September 2022, the RBA forecast inflation to be around 4 per cent next year, and not lowering to 3 per cent until late 2024 when factoring in further anticipated increases to the cash rate. In the latest Statement on Monetary Policy in November 2022, the RBA has revised its forecast to 3 ¼ per cent by the end of 2024.
3.7
The RBA views the path to lower inflation as a ‘narrow one’, noting that limited profit margins and curtailed wages growth are essential for inflation to sit within the target band. While conceding this would mean a decline in real wages and that this was a difficult message for people to accept, the Governor emphasised that it was vital in tackling inflation:
… we are relying on wages growth not picking up too much more [and] … on profit margins not rising further—in fact, coming back a little bit in some industries as demand stabilises … I know it's not a comfortable message for people that we're going to have a decline in real wages this year. It's tough … But next year, if our forecasts come to pass, inflation will be a bit above four, and the broadest measure of growth in wages—which is from the national accounts average earnings per hour worked—will be close to five. Next year we are expecting real wages to be positive and the following year to be even more positive. This year it's negative, wages growth is much less than inflation, and that's really tough for people. But if we hold together on … growth in our real wages and profit margins, then next year we can look forward to growth in real wages again.
3.8
The committee also discussed the RBA’s expectations for the level of rate rises. The Governor advised that the interest rate ‘should at least average the midpoint of the inflation target’ but suspected it should average higher if there was productivity growth in the economy, leading to a higher real interest rate. The Governor further explained that while it is difficult to be specific, he believed that the RBA will ‘cycle around some number between 2 ½ and 3 ½ per cent’.
Timing of rate rises and their cumulative impact
3.9
Another key issue was the timing of interest rate rises, considering there has been seven consecutive increases since May 2022. The committee asked how the RBA factored the cumulative impact of rate rises into their decisions, and whether pausing rises to observe the impact was a viable option.
3.10
The Governor explained the ‘case for large adjustments in interest rates has diminished’ as the current rates are now closer to a normal setting. However, the RBA was ‘very conscious’ of the cumulative impact of rate rises:
The evidence we have from the past is that when we change interest rates the maximum effect on economic activity is roughly 18 months to two years afterwards, and then it takes a while for that to feed through to inflation. So there is a two-year lag before we see the maximum effect of that. That's understandable, because when you think about the transmission mechanisms of monetary policy, one is the exchange rate, so the exchange rate changes, and then it takes time for firms to change their investment and sourcing decisions. Another is through changes in the housing prices, which we talked about before. That affects spending, but it takes time for people to do that, and then once people change their spending, it takes time for firms to adjust their investment plans. So by the time you go through all these layers—they're quite long effects, and we are very conscious of that. This is one of the reasons we have to forecast.
3.11
Expanding on the RBA’s forecasting of the cumulative impact, the Governor highlighted that the level of previous and continuing interest rate rises was a consideration when setting monetary policy, but that there was also complexity from trying to understand the time-lag effects of additional savings built up by households during the pandemic. This brought additional uncertainty:
… is the level of interest rates roughly expansionary or contractionary or neutral? Put together, the assessment level—it's getting close to normal and probably still a bit low. And the lags—it's difficult because the lags change through time as well. We know that households have built up all these buffers. Some people argue it allows households to smooth through interest rate increases in a way they mightn't have done in the past. In the last two years, in aggregate, households saved an extra $250 billion over and above what they normally would have in a two-year period. That's a lot of money, and it's not evenly distributed. So that's another thing we're factoring in: how are people going to use that extra $250 billion? Are they going to let it sit there and be part of their accumulated wealth or are they going to draw down these buffers? This is why there’s so much uncertainty at the moment, because there are a lot of moving pieces.
3.12
The Governor cautioned that even with further increases to interest rates incorporated into the RBA’s forecasts, inflation is forecast to remain above 3 per cent in two years’ time and ‘the longer it stays above 3 per cent the more difficult it is going to become’. Additionally, the RBA’s actions are watched closely and have real effects on the behaviour of the community and of markets. This is why, the Governor added, the RBA could not afford to pause rate rises until the cumulative impact of recent increases was known, as a pause would have signalled to the public a misleading lack of concern about future inflation:
If we took no action, and interest rates didn’t go any further, or we hadn’t moved last month, there would be a high probability that the community would think that we’re not serious about getting inflation under control, that inflation expectations would adjust, that people would think, ‘The Reserve Bank isn’t really serious about this, so I’d better factor higher inflation into my ongoing decision-making’.
Household spending and consumer sentiment
3.13
Rising inflation and interest rates mean households have less capacity to meet their increasing housing costs—whether loan repayments or rent—while maintaining their consumption and rates of saving. In its October 2022 Financial Stability Review, the RBA identified that strong employment growth has supported household incomes and that there has been pressure to reduce the rate of saving, but that households are nonetheless continuing to save.
3.14
The Governor explained that household spending is an issue the RBA will continue to monitor closely given ‘considerable uncertainty’ as to how it will balance with higher rates and inflation in the future. Current spending data indicated that spending is ‘pretty firm’. However, the Governor noted that sentiment was brittle with consumer confidence ‘quite weak’. Addressing the committee’s concerns about a potentially severe response to inflation where consumers cut spending considerably, he explained that if this did occur, ‘the profile of interest rates is obviously lower’.
3.15
The committee appreciates that inflationary pressures have been driven by both supply-side constraints as well as strong domestic demand. While monetary policy adjustments—specifically increasing the cash rate—can be effective in moderating domestic demand, the committee expects the RBA to continue to exercise nuanced judgement to ensure that this instrument is not inappropriately deployed in response to supply-side inflation pressure.
Forecasting inflation and lessons learnt from recent errors
3.16
The committee scrutinised the RBA’s forecasting of inflation and how it compared to other central banks. It also queried the data the RBA used in its forecasts, and the lessons learnt from not forecasting the high levels of inflation currently being experienced in Australia.
3.17
The starting point for understanding RBA forecasting is its quarterly Statement on Monetary Policy, which sets out the Bank’s assessment of current economic conditions, both domestic and international, along with the outlook for Australian inflation.
3.18
A current criticism of the RBA is that its forecasts failed to predict the inflation surge of 2022. In November 2021, the RBA’s forecast was for:
… underlying inflation to pick up gradually over the next couple of years, as the economy recovers further and spare capacity is absorbed. In the central scenario, trimmed mean inflation is forecast to be 2 ¼ per cent at the end of 2022 and around 2 ½ per cent by the end of 2023.
3.19
This figure was revised to a higher level in February 2022 but, with the benefit of hindsight, remained very conservative. At the time, the RBA noted ‘considerable uncertainties’ surrounding the outlook and a lack of historical experience to draw upon:
Underlying inflation is forecast to peak around 3 ¼ per cent in the next few quarters, before returning to around 2 ¾ per cent as some of the shorter-term cost pressures abate.
3.20
The RBA conceded to the committee that it had made forecasting errors but noted that its assessments aligned with those of other central banks. In August 2021, for example, most central banks expected inflation in 2022 would be between 2 and 2 ½ per cent—however Europe, the US and Canada are currently experiencing inflation figures between 8 to 11 per cent.
3.21
Adding further context to its thinking at the time, the RBA noted that when these inflation forecasts were made Sydney and Melbourne were in lockdown, and its forecast had assumed further lockdowns in Australia throughout 2022.
3.22
Also complicating the forecasting picture, the RBA had been forced to grapple with the complex economic consequences of global events—which are extremely difficult to predict—and its understanding of their implications. The RBA cited Russia’s invasion of Ukraine as an example:
The question is how much of the forecast miss is due to those generally unforecastable events versus our lack of complete understanding of what the implications of that event were once it had already happened. We were correct in understanding that that event meant gas prices in Europe in particular would increase, that they would increase more than in Asia and, in turn, more than domestically, because the gas markets globally are not fully connected and so there is not pure price arbitrage. We knew that. What we didn't fully understand was that the transmission through coal prices was going to have a whole range of effects on our own electricity market—so our initial assessment of what this would mean for electricity prices domestically was not quite right. Should we have understood those dynamics in the electricity market better? That's just one example.
3.23
The RBA told the committee that it has since made ‘material improvement’ in its approach to near-term forecasting due to the availability of new datasets. It can now draw from its new consumption tracker (using data sources such as card transactions, restaurant bookings, flight departures, Medicare benefits and mobility data), for example, in combination with its Business Liaison Program.
3.24
On lessons learnt, the RBA advised that it is always seeking to understand its forecasting errors and improve its future methods. Under its existing governance processes, the RBA evaluates its previous forecasts and reports back on these to its board annually. However, at its November 2022 meeting, it would be doing this ‘with extreme vigour’ because of the scale of the RBA’s forecasting errors.
Communicating forward guidance and lessons learnt
3.25
Forward guidance refers to central bank communications regarding the state of the economy and the likely future course of monetary policy. In its February 2021 Statement on Monetary Policy, the RBA Board stated that:
The Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at the earliest.
3.26
The committee asked the Governor what lessons were learnt from the RBA’s implementation of very direct forward guidance, such as the above, which ultimately proved inaccurate. The committee pressed the RBA on whether it would have been preferable to avoid such a long forecast horizon and to have instead used less specific language about timing, given that Australians are more likely to focus on those dates rather than the conditionality that is also provided in the forecasts.
3.27
The Governor responded that the RBA was undertaking an internal review of forward guidance, (since published on 15 November 2022) and that:
People expect us to provide forecasts. Those forecasts always have a lot of caveats, but, rightly, the community expects us to put our central forecasts out there, so we do that. The next thing we do is try and explain our reaction function—how we're going to move interest rates in response to various variables. So we put forecasts out there, and hopefully people understand our reaction function. Up until the pandemic, people would then draw their implications for what that meant for the timing of interest-rate increases. That's how it has worked for a long period of time.
3.28
However, during the pandemic the RBA took a different approach and was ‘very explicit’ about what it thought that the reaction function meant about the timing of interest rate increases. The RBA Board’s motivation for being more explicit was to communicate its continuing support for the economy and to provide certainty:
… we wanted to use every instrument in our toolkit to provide support for the country. We wanted to provide insurance against the possibility of a very bad outcome … it was a unique period in our economic history, and the communication responded to that. We wanted people to understand that we thought the pandemic was going to be damaging to our economy, but the Reserve Bank would be there with them. We would keep interest rates low for however long it was necessary to get us through this.
3.29
The Governor added that while the RBA was only ‘one voice out there’, it was evident that its communications were being acted upon, for example when there was a large increase in the number of households taking out fixed-rate loans during the pandemic in ‘part because of’ the RBA’s statements.
3.30
The Governor indicated that there was a balance in providing forward guidance that is overly specific with the community’s expectations for transparency, and that the RBA will be ‘much less inclined’ to provide similar guidance in the future. The committee notes that the RBA has now published its internal review on forward guidance, which outlines the Bank’s proposed future approach to the issue. In particular, the committee welcomes that the RBA’s approach will emphasise flexibility, that conditionality will focus on policy objectives (inflation and unemployment) rather than wages, and that forward guidance will typically focus on the short-term and be narrative in nature.
Inflation psychology and expectations
3.31
Inflation expectations are the beliefs held by households and firms about future price increases. These expectations are important as they can affect current economic decisions which can then, in turn, influence actual inflation outcomes. For example, if workers expect future inflation to be higher, they may demand higher wages to make up for the expected loss of their purchasing power—a behaviour often referred to as ‘inflation psychology’. This can contribute to a higher rate of actual inflation so that expectations about inflation become self-fulfilling.
3.32
In the RBA’s view, managing inflation expectations and inflation psychology are key factors to success in navigating Australia’s current high inflationary environment. While medium-term inflation expectations were ‘well anchored’, there remained uncertainty, and the general inflation psychology ‘does appear to be shifting’.
3.33
The Governor highlighted that wages growth has not been a factor in driving inflation, unlike the situation in the US, and that at the aggregate level, growth in labour costs remains consistent with inflation returning to target. However, tightness in the labour market was raised as a potential issue if businesses start trying to attract workers by increasing wages.
3.34
Inflation expectations are also used to calculate nominal and real interest rates. Nominal interest rates refer to the cost of borrowing money including compensation for inflation, whereas the real interest rate is calculated net of inflation expectations.
3.35
On this theme, the committee discussed the RBA’s preference to calculate the nominal interest rate using the long-term inflation expectations of 2 ½ per cent, rather than the current inflation rate which is considerably higher.
3.36
In response, the Governor justified the RBA’s approach to calculating interest rates by referencing the central importance of inflation expectations and inflation psychology. If the expectation was inflation remaining at high levels over the long-term, then interest rates would ‘have to go up a lot’ and damage the economy severely. The Governor outlined that:
… if you use the current inflation—let's say 7 per cent, which is what it will be later in the year—to have a neutral setting of interest rates in Australia, you would need the cash rate to be at least 7 per cent. My judgement and the judgement of most of my colleagues is that that would be incredibly contractionary for the economy and would throw us into a sharp recession. So I don't think that's the right way of thinking about what the neutral nominal rate is at the moment.
Impact of interest rates on mortgage holders and renters
3.37
From November 2020 to April 2022, at the height of the COVID-19 pandemic, the RBA’s cash rate was a record low 0.1 per cent, correlating to average retail interest rates for mortgages of 2.86 per cent for outstanding loans, and 2.41 per cent for new loans.
3.38
Since the RBA’s last appearance before the committee in February 2022, it has raised the cash rate to 2.85 per cent (as of November 2022), with mortgage holders seeing retail variable interest rates averaging 4.88 per cent for outstanding loans and 4.38 per cent for new loans.
3.39
At its September 2022 public hearing, the committee examined the impact of recent interest rate rises—occurring monthly since May 2022—on mortgage holders and renters. The committee was concerned about the societal distribution of these impacts and sought to understand the RBA’s methods for assessing the economic response to rising rates.
Mortgage holders
3.40
The RBA told the committee that in the case of owner-occupiers, the situation is nuanced. Changes to mortgage interest payments relative to income were ‘quite an important consideration’ in its decision-making process. However, to address the current high inflationary environment, rate rises could not be avoided:
I’ve said this before: it’s very difficult for people, but—this is the point—it will be even more difficult if inflation stays high. If you’ve got a mortgage, you don’t like higher interest rates—we understand that—and it hurts.
3.41
The RBA then expanded on the ‘very uneven’ distributional impacts of interest rate rises on mortgage holders.
3.42
At the worst-affected end of the spectrum, the RBA’s forward-looking analysis suggests that approximately 15 per cent of borrowers would not have any spare cash flow by the end of 2023 due to rate rises and increases to the cost of living. This cohort:
… have quite high debt and very little in the way of pre-payment buffers—less than three months’ worth of excess mortgage payments. Those households—the high-debt, low-buffer households—tend to be the ones that are disproportionately populated by low-income households—so they have less ability to trim their expenditure.
3.43
At the same time, there is also a cohort of borrowers who are unlikely to experience stress in their mortgage repayments. These are the households that had accumulated savings during the pandemic—at the aggregate level household savings expanded markedly at that time—and now have the ability to draw down on those savings as rates rise.
3.44
Additionally, the RBA outlined that around one-third of borrowers, both on a fixed or variable rate, ‘are not going to have any increase to their actual realised payments out to the end of next year’. This is a result of the length of fixed loans being offered during the pandemic, as well as some variable rate borrowers who had already serviced a higher repayment towards their mortgage to such a degree that the mortgage would remain unchanged by an increase in rates. The committee considers that it is important that rigorous distributional analysis continues to inform the RBA’s decision-making.
3.45
Further, on this issue of housing stress, the committee raised the Australian Prudential Regulatory Authority’s serviceability buffer, which is used by banks to assess whether a mortgage applicant can repay the proposed loan at a higher rate—typically 3 per cent above the rate at the time of application. In response to committee questioning on the suitability of the current buffer rate, given that interest rates are likely to continue rising, the RBA outlined that the 3 per cent buffer is ‘around what other countries have’ and that the current level is sufficient:
I think the serviceability buffer is providing what's required. And it's worked in the past in the sense that, as we discussed earlier, even though interest rates have gone up, many households—not all households but many households—have found that they do have space because the space was built in in the first place.
Renters
3.46
The committee also asked the RBA about the impact of interest rate rises on those who rent, given there has been a 12 per cent annual increase in the price of new advertised rents in combination with a very low national vacancy rate of below 1 per cent.
3.47
In response, the RBA acknowledged that ‘there are a growing number of households that are feeling real strain on their household budgets’, noting that around one-third of Australians who rent are on lower incomes. In the current high-inflationary environment, this group of renters have a higher share of consumption of essential goods—which have also been rising in cost.
3.48
In addressing the committee’s concerns at the prospect of rising interest rates resulting in further increases in rental prices, the Governor argued that the influence of interest rates on rents is not straightforward:
I don't think there is much of a link between when we increase rates by 50 basis points and what people pay in rents tomorrow. Many rental contracts are for one year, so the flow through is slow, and many landlords don't put up their rentals just because interest rates are going up. I'm not denying that interest rates are an influence on rents; I just don't think they are a first order influence for most rentals.
3.49
Instead the RBA viewed increasing rental prices, based on its analysis of empirical data, as primarily the ‘inevitable outcome’ of rising household incomes coupled with a nationally low vacancy rate.
3.50
Additionally, structural shifts in society, such as substantial increases in people working from home, are influencing rental prices. This is putting pressure on the supply and demand for rental dwellings:
People want more floor space when they are working from home, so the demand for floor space has increased and that puts pressure in the market. That is the primary thing that is going on here. The additional supply of new apartments in the last year or two has been fairly small and the demand for apartment floor space is rising again because people work from home.