Why Interest Rate Hikes and Inflation Strategy Could Lead to Economic Exhaustion

0

Inflation and rising interest rates are causing enormous pressure on everyday Australians – and there is a worrying sign that we are heading towards ‘economic burnout’.

On Wednesday, the release of the latest inflation figures from the Australian Bureau of Statistics revealed that Australian inflation was well and truly outside the Reserve Bank’s target range of 2-3%. With annual inflation of 5.1% recently, the cost of living as measured by the ABS Consumer Price Index (CPI) is rising at the fastest rate since the introduction of the GST more than 20 years old.

In this case, Australia is not alone, with virtually every country on the planet currently struggling with high inflation. In the United States and Europe, inflation is even higher, reaching 8.5% in the United States and 7.4% in the European Union.

Historically high levels of inflation were dealt with by central banks raising interest rates to remove aggregate demand from the economy until inflation was brought under control again.

Around the world, that’s exactly what central banks typically try to do, which is to aggressively raise interest rates to put downward pressure on inflation until it’s brought under control. at the desired level.

But unlike previous economic cycles, when central banks were largely on their own to fight inflation, in the post-pandemic world where government intervention has become a regular occurrence, policymakers around the world are trying also their own solution.

Respond to cost of living pressures with more government money

In Australia, the Morrison government tried to counter the rising cost of living by halving the fuel excise tax (22 cents per litre) and providing one-time payments to welfare recipients.

In Japan, the government has pledged to spend 13.2 trillion yen ($142 billion) on an emergency relief package to ease the pain of households and businesses hit by rising costs. The package includes subsidies to gasoline retailers, cash payments to low-income households with children, and the extension of financial support for small businesses, along with several other support mechanisms.

In the United States, the Biden administration extended the student loan repayment holiday through December, giving households with student loans an additional $8.1 billion a month.

Meanwhile, several US states have suspended or reduced state gasoline taxes, while others, such as California, plan to provide cash payments or vouchers to vehicle owners.

As you can see, there is a certain trend in the reaction of governments around the world to the rising cost of living, it is actually trying to solve the inflation problem with more money.

In fairness to the three nations cited as examples, they are far from being outliers compared to their peers. Around the world, governments are trying to use their resources to cushion the impact of rising inflation on households and businesses.

But doesn’t this spending increase inflationary pressures? I imagine that some of you may think that is indeed the case.

Central banks are going the other way

While political leaders continue their attempts to fight inflation by providing additional funds to households and businesses, the world’s central banks are pushing in the complete opposite direction.

Across Tasmania, the Reserve Bank of New Zealand began raising rates in October and raised rates cumulatively by 1.25%. The New Zealand branch of ANZ estimates that the cash rate will peak at 3.5%.

In the United States, the market currently expects increases of 1.75% in the federal funds rate (US equivalent of the RBA cash rate) over the next three meetings of the Federal Reserve. At the end of the year, the market expects a federal funds rate of 2.75% to 3%.

At home in Australia, there is growing speculation that the RBA may raise rates as early as next week. With AMP and ANZ adjusting their forecasts this week for a May 3 rate hike.

Currently, the RBA spot rate futures market forecasts a spot rate of 2.47% by the end of the year and 3.28% by the middle of next year. .

In other words, central banks seek to quickly curb inflation by rapidly raising interest rates to counter inflationary pressures.

The economic showdown

As governments continue to inject liquidity into the economy as central banks try to take it out by raising interest rates. We effectively end up with a series of policies that are akin to having one foot flat on the accelerator, while the other is hard on the brake.

This strategy is what I like to call the burnout economy. Just as a burning car causes smoke, noise, and not much forward momentum, these two forces work against each other.

As lockdowns continue in China and war continues to rage in Ukraine, raising rates high enough to bring inflation down to a level consistent with central bankers’ goals was always going to be difficult. By adding additional spending at a time when inflation is already at multi-decade highs, this challenge becomes even more difficult.

The more cash pumped into the economy by governments trying to cushion the blow of inflation, the more central banks may need to raise interest rates to counter rising inflationary pressures.

In Australia, interest rate futures markets continue to price in an extremely rapid and large rate hike cycle from the RBA. Until relatively recently, few mainstream economists shared his view that this would happen.

But with inflation well above expectations, suddenly one wonders if the market is even partially right that an aggressive rate hike cycle is needed to get inflation under control?

Ultimately, we live in very uncertain times, defined by the pandemic, the war in Ukraine and near-unprecedented commodity prices. Central banks may be able to control inflation in their usual way by reducing demand within the economy.

On the other hand, rates may need to rise significantly as various factors combine with the widely employed strategy of the burnout economy that continues to support inflationary pressures.

Tarric Brooker is a freelance journalist and social commentator | @AvidCommentator

Read related topics:ASX Reserve Bank

Share.

Comments are closed.