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Why the RBA has been ineffective in curbing inflation

In the aftermath of the financial crisis, the monetary policy mantra was ‘lower for longer’. In a post-pandemic world, that has been replaced with ‘higher for longer’ to keep inflation down. 

One would think that if monetary policy worked, there would be no need to keep waiting ‘longer’ to get the desired policy outcome. Despite a zero-interest rate policy and unending quantitative easing (QE), Japan has waited 25 years for inflation to re-emerge. That policy was ineffective and talk about waiting a long time!

Even our own Reserve Bank of Australia (RBA) arguably falls into this category of ineffectiveness. After the recent June monetary policy decision, the central bank board indicated the economic outlook was "highly uncertain”. This highlights a lack of confidence in the central banks’ own framework and policy prescription for the current environment. This is of little comfort for the future 200,000 to 300,000 people targeted to lose their jobs in the name of its monetary policy prescription.

And that prescription may not work to lower inflation into the bank’s 2 to 3 per cent target band. If anything, there appears to be a positive correlation between interest rates and inflation. That is, higher interest rates cause higher inflation, as the charts below suggest.


Source: ABS, RBA, Quay Global Investors

Other examples

Outside of Australia and the US, we have additional examples of the lack of effective impact of monetary policy. Japan is a classic case in point. However, we note some like to make excuses for Japan, such as its old demographics. But we can see inconsistencies between monetary policy and inflation just about everywhere we look.

Moving to another part of the world, the charts below highlight the data between the Czech Republic and the Euro member, Slovakia. Both countries share similar demographics and geographies. And as such, both had similar economic growth of around 1% gross domestic product (GDP) growth in 2023. Despite the delay in interest rate hikes in Slovakia, and a lower end cash rate, the inflation outcomes for both countries are identical. Surely, if interest rates worked effectively, these like-for-like examples would show different inflation outcomes.


Source: Fred, OECD, Quay Global Investors

Whether it’s the US, Australia, Japan, Slovakia or the Czech Republic, the data simply does not support the idea that interest rates deliver desired inflationary outcomes.

Reasons why rates have little impact on inflation

Generally, there are three reasons for this. First, monetary policy advocates argue changes in interest rates impact borrowers; higher rates are negative, curb spending, and slow the economy with a corresponding decline in inflation, while lower rates are positive. However, as we have written previously in our Modern Monetary Theory Part 2 article, and as highlighted by the Bank of England, loans create deposits. That is, for every private creditor there is a private debtor. Therefore, any pain or benefit felt by a borrower from a change in interest rates is offset exactly by the pain or benefit felt by savers or deposit holders. Higher interest rate may hurt some, but it also allows other people with money to earn more money.

It’s little wonder then why, in the current rising interest rate climate, luxury retailers are trading so well while low-income retailers are struggling. From a private sector income flow perspective, monetary policy is like driving a car with one foot on the accelerator while the other is on the brake. Different dynamics are at work and it's not just a slowdown.

Second, higher interest rates add to the money supply. An emerging excuse for why interest rate policy is not working as intended is that the government is ‘spending too much’, which is working against the central bank’s actions. Of course, the main reason governments are spending is because of interest rate policy.

Take the US, for example. Like most countries, the US government has a net debt position. This means any interest paid is a net positive flow to the private sector. As interest rates increase, this flow accelerates, effectively becoming stimulus. In this context, is there any surprise the US economy recovered so strongly after the US Federal Reserve began to increase interest rates? And since GDP growth began to accelerate, inflation has declined.

Finally, higher interest rates increase the cost of production and prices. One of the long-held economic beliefs is that higher wages lead to inflation. Quite often referred to as a ‘wage-price spiral’, the idea is simple enough. Higher input costs for businesses are readily passed onto consumers – who in turn demand higher wages, and so forth.

What is less discussed is businesses also have a ‘cost of capital’. Higher labour costs can be passed on, why not higher capital costs? We see this today in real estate, especially housing. Current interest policy has resulted in a higher cost of funding, and hence, making new projects less viable. Less supply results in higher prices and rents, feeding into higher inflation.

Best to ignore the RBA

The bottom line is that the use of interest rates policy as a tool for controlling inflation is an accident of history. It should, therefore, come as no surprise its track record is dubious, at best. At Quay, we never position for interest rate policy. It seems jumping from one policy statement to the next is not helpful when investing, especially when those making the statements are equally lost and confused as the impact of their own policy choice.

Instead, we fundamentally believe that buying high-quality companies with structural tailwinds and deep discounts is the best way to preserve capital and generate sustainable long-term returns. For long-term investors, interest rates matter far less than total returns driven by earnings growth and dividend yield. And if history is any guide (see the chart below), we’ll be proven right.


Source: Jack Bogle, Ben Carlson, Quay Global Investors

 

Chris Bedingfield is Principal and Portfolio Manager at Quay Global Investors. This article contains general information only, and does not constitute financial, tax or legal advice. It has been prepared without taking account of your objectives, financial situation or needs.

 

16 Comments
Vince Vozzo
August 16, 2024

The real driver of inflation presently is government both federal and state.
Taxes that feed into inflation are petrol excise and liquor excise ( both lifted twice a year for no reason other than revenue), tobacco excise and tax on insurance policies.
At state level in Victoria you have the massive increase in Land Tax together with payroll tax and council rates.
Lower inflation could be achieved by lowering these taxes.

Trevor
August 18, 2024

Land tax is set to rise in NSW too with the government freezing the threshold.

If we must have land tax on residential land than levy it on all residential land at a low rate rather than target landlords and holiday home owners. But that won’t happen because it’s easier to target said group.

Economist
August 21, 2024

Land tax isn't in the CPI nor any other inflation measure. Nor should it be.

Steve
August 16, 2024

Interesting how Australia and the US have the same macroeconomic tools but the vast majority of mortgages in the US are 30 year fixed and in Australia mainly floating rate. I would urge the government to peruse more fixed rate loans so that the rate you agree to at the start of your loan stays constant and all this talk of hammering mortgage holders can stop. Of course new mortgages get more expensive and still impact demand which is part of the objective. I honestly scratch my head every time this issue is discussed why fixed rates ala the US hardly rates any discussion in financial newsletter such as firstlinks.

Kevin
August 19, 2024

Why would you change a system that works ( Australia),for a system that didn't work ( the USA).As far as I know the US is the only country that has that system.

Fannie Mae and Freddie Mac went bust during the GFC,the backstop of that system.The US has banks that go bust regularly,a small state based banking system,with a few big banks countrywide.Did state banks in Australia disappear?

It is not up to everybody else to manage risk for you,you manage it yourself.Super funds are not there to provide cheap loans to people,as much as they seem to think that should be the case.The govt is not there to rescue everybody that blew themselves up.

What do you think would've happened to super funds if the 4 big banks had gone bust during the GFC?. Let people get on with complicated financial engineering, Australian banks are building societies,fairly simple,take money in,raise money elsewhere,operate on 2% net interest margin and around 1% net.They still try to blow themselves up.

Think of the mortgage lenders that went bust here,RAMS, Wizard and that ilk,and perhaps Suncorp came close with their financial engineering that was the "future".St George Bank that disappeared seemingly overnight after saying we only have around 50 mortgages in stress. Don't cherry pick around the world saying I want this that and the other without looking at what happens if you have this,that and the other.

John Abernethy
August 16, 2024

Well written article in my opinion and consistent with what I wrote last week.

Interest rate increases add to both the cost of living and the cost of doing business.

Yes, interest rate increases affect the demand of highly mortgaged households by reducing their disposable income after interest- but it has no effect on households who own their own house.

Higher interest rates push up rental charges sought by investors/owners who seek to recoup the interest on their leveraged property investments.

A loss of purchasing power will see workers seek recoupment ( higher wages) against the increased cost of living.

I agree - as I stated last week - that there is abundant evidence that excessive fiscal deficits do not necessarily stoke inflation.

The decade that followed the GFC showed this clearly and it was a period of QE and money supply growth, which economic theory had categorically and dogmatically suggested that inflation would surely follow. It was a covid crisis followed by the Ukraine war that stoked cost price inflation reminiscent of the 1970s. The oil price crisis of the 1970s is similar to the energy price crisis of 2022.

Cost inflation translates into further cost inflation as wage earners seek a catch up unless the Government sensibly intervenes with income tax cuts or cost of living relief. It requires strong leadership and a clear plan that includes replacing Fair Work wage increases with income tax cuts.

In any case both the RBA and successive governments ( advised by Treasury) have stoked the greatest housing price bubble - extreme asset price inflation - that Australia has experienced outside the direct effect of World War 2.

The increased cost of housing and the observation of extreme unaffordability will remain an undercurrent to the real cost if living - whether it is appropriately measured in the CPI or not.

Dudley
August 16, 2024

"has no effect on households who own their own house": Err, increased interest adds to their savings.

"The decade that followed the GFC": China vacuumed up commodities, exhaled cheap goods, built debt mountain = deflation; seen as a problem by the dogma of central banks = must stimulate = QE. China CoVID offline = inflation. Fog of Future = delays in response = swings in outcomes.

"greatest housing price bubble": Fixable by raising real net interest rates = stop repressing interest rates and stop taxing imaginary interest.

John Abernethy
August 16, 2024

Hi Dudley

Let's be a bit fair - I was clearly stating that higher interest do not have a negative affect on the consumption of households that do not have debt. By the way - to add to their savings ( i think you mean investments or capital) they must have investment capital and reinvest the income.

No idea what your second paragraph means.

Third paragraph - Yes, we can fix a housing bubble by blowing it up (raising real interest rates) or we can be a little bit more considered by bringing it down through careful management and planning. I covered that last week.

Dudley
August 16, 2024

"i think you mean investments or capital": Money, as in cash, more particularly bank deposits - which is capital.

"No idea": Chinese exported cheaper goods. Good deflation. Makes consumers wealthier, at cost of manufacturing jobs.

"fix a housing bubble by blowing it up": Better to implode it - so flying fragments don't start a chain reaction.

John Abernethy
August 16, 2024

Dudley

How does a property market collapse inwardly? Is that what mean by implosion?

In any case - How does a housing collapse not cause collateral damage to financial institutions ( the banking system) and the economy?

Dudley
August 16, 2024

"How does a property market collapse inwardly?":

A slow decay in price to buy / rent (relative to incomes). Suck money out of homes to RECYCLE in other sectors - particularly create competitive alternative investments through increased real net interest rates.

As you allude, an explosion, even a too rapid decay, risks unrewarding damage.

There are many economic threads interlaced with homes and many possible ways to control aspects of the beast. Many commenters describing and bewailing fragments, like the blind describing an elephant.

Warren Bird
August 15, 2024

But they haven't been "ineffective"! Inflation has been reduced from 8% to just under 4%. Money supply growth has been slowed and supports a continued decline in inflation.

And to further contradict the argument, it was excessively low interest rates for too long during the pandemic, ignoring the blow out in excess demand supported by very strong money supply growth, that caused the inflation outbreak in the first place.

I agree with those who believe we should seek to use other policy tools to support the monetary instrument of changing interest rates , but it is patently wrong to believe that the RBA and the interest rate instrument is ineffective. The issue is that it works a bit too bluntly with the distributional consequences now getting quite a bit of attention.

A technical note about the true statement that bank lending creates deposits. Yes, money is created in two ways: 1) by banks creating loans and 2) by government deficits that are funded by central bank bond buying (monetised). The former is the far more significant influence. And yes, every loan written creates deposits within the banking system. That is why money supply is measured using deposit data, rather than loan data. But none of that means that borrowers don't have a cash flow squeeze when rates go up, which is vital for having an impact on net demand in the economy. Households and businesses in Australia are net debtors. That's why interest rates work.

Neil
August 15, 2024

“If anything, there appears to be a positive correlation between interest rates and inflation. That is, higher interest rates cause higher inflation, as the charts below suggest.”

A classic case of confusing the two related but different concepts of correlation and causation. I would suggest that higher INFLATION CAUSES higher interest rates rather than the other way round – they are still correlated. Evidence: every central bank in the world justifying why they decide to increase their cash rates, that all commercial interest rates are benchmarked to.

Jemal
August 15, 2024

Agree. There are also lag effects, not mentioned.

Cam
August 15, 2024

I've always wondered why the only tool we seem to use to fight inflation is interest rates. When I was a new home owner around the GFC I was also aware that higher interest rates hit this demographic and businesses with loans, while retirees and young savers with bank deposits get more money.
Maybe increasing the super guarantee rate for a year could be used. Modern super started in the 1980's to address inflation. A temporary tax increase does the same thing, but helps Government debt instead of private savings benefits of super. I'm sure there's better ideas than I can come up with.

GeorgeB
August 22, 2024

“only tool we seem to use to fight inflation is interest rates”
Two reasons why this may be considered reasonable/appropriate are:
For home owners and businesses with loans-Inflation reduces the real value of their debt because inflated dollars are used to repay it.
For retirees and young savers with bank deposits - Inflation also reduces the real value of their savings.
In both the above scenarios increased interest rates serve to even up the balance (at least in part) .

 

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