How high can inflation go?

Dr Ben Wang
22 August 2022
Macquarie Business School


While the current spike in inflation is being driven by factors beyond the control of the Reserve Bank, there is a lesson it should heed from Australia’s past, explains Dr Ben Wang from the Macquarie Business School.

The Reserve Bank of Australia (RBA) has moved aggressively this year to try to tame inflation, but the disruption of global supply chains brought about by the pandemic, the shuttering of China’s manufacturing centres and Russia’s invasion of Ukraine are proving problematic for the central bank and policy makers.

Australia’s headline inflation rate hit a 21-year high of 6.1 per cent in the June quarter, driven by higher petrol and food and beverage prices, as well as growing home building costs. Underlying inflation – the central bank’s preferred measure – rose 4.9 per cent for the year.

Outside of the introduction of the GST in 2001, annual growth in headline and underlying inflation is the fastest it has been since the early 1990s In order to rein in inflation, the RBA has moved aggressively to slow the economy. There have been four successive interest rate hikes this year, taking the official cash rate to 1.85 per cent and further increases are expected.

Inflation expectations

The current spike in the cost of living is different from other economic ‘shocks’ in recent decades as this one is being driven primarily by a disruption beyond Australia’s control – rising petrol and energy prices as well as ongoing disruption to the global supply chain.

If history teaches us anything, then the cost of oil and energy and the ongoing challenges of a disrupted supply chain remain an important determinant when it comes to the future of inflation.

The problem for the RBA is that supply-side issues are largely independent of monetary policy decisions, making interest rate increases a less-effective tool when it comes to thwarting inflation.

Inflation expectations play an important role in driving inflation because they can create self-reinforcing loops that further fuel price pressures.

For instance, once people start to raise their inflation expectations in an existing inflationary environment, the cost of wages and raw materials tend to rise, which in turn forces businesses to further lift prices. This behaviour itself is inflationary and worsens the outlook in an environment where prices are already being driven higher due to supply chain disruptions and rising energy prices.

At the same time, higher inflation expectation may give a false impression that borrowing money at a given interest rate is cheap, in turn stimulating demand which further fuels inflation.

Lessons learned

Our last major experience with persistent high inflation was in the mid-1970s to mid-1980s when restrictions on oil production fueled a significant rise in oil prices. Australian inflation topped 17 per cent with inflation expectations not far behind.

We learnt two key policy lessons back then: Inflation expectations tend to quickly adjust to a rapid increase in inflation and; it is essential to set the monetary policy rate (does this mean the interest rate?) above inflation expectations to break self-reinforcing feedback loops between inflation and inflation expectations.

This sharp increase in the central bank interest rate to 12.5 per cent in Q2 1974, then again to 18.5 per cent in Q2 1982, brought about sudden economic contractions, producing painful economic downturns that macroeconomists typically refer to as the downturn `we had to have’.

According to the Melbourne Institute Survey of Consumer Inflationary and Wage Expectations, consumers in July 2022 expect prices will grow at 6.3 per cent over the next 12 months, a rapid increase from 3.7 per cent a year ago.

Moving forward

If history teaches us anything, then the cost of oil and energy and the ongoing challenges of a disrupted supply chain remain an important determinant when it comes to the future of inflation.

Although the RBA does not have direct control over these factors, it can continue to take a hawkish stance against inflation so that medium-term inflationary expectations remain tempered.

This should go some way to prevent further aggressive tightening and avoid producing another recession `we had to have’.

Dr Ben Wang is a Senior Lecturer in Economics at the Macquarie Business School and a member of the Centre for Risk Analytics.


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