The Inflation-Interest Rate Puzzle: Is The Interest Rate Too High?

The question of inflation has remained centre stage in Australia as inflation hit a new high of 7.8% and the interest rate, a new high of 3.5%, with no end in sight. Four months ago, I had written an article on the nature of inflation, asking whether this inflation was transitory as claimed by the Fed, a claim which had delayed the increase of the interest rate.

At the time of writing and today, many commentators have been concerned with the rising inflation rate, stating that a recession could be induced without warrant, especially if inflation is being caused by supply side issues. So how are we to look at the actions of the RBA and of central banks globally in combating inflation, how do we understand the situation we are in?

In my previous article, I provided two perspectives which are popular in economics regarding inflation, the Quantity Theory of Money (QTM) and cost-push inflation.

To provide a quick summary of the two, the QTM states that a rapid expansion in the quantity of money above the quantity of goods will cause inflation because, “too much money is chasing too few goods”. Cost push inflation is an alternative theory which states that inflation occurs when the cost of non-substitutable goods of consumption and production increase in price due to inelastic demand.

Either theory will lead us to be concerned with how responsive aggregate supply is to aggregate demand, as excessive aggregate demand will cause inflation. Therefore, the central bank is interested in managing aggregate demand and the only tool at its disposal is the interest rate. Thus, to understand whether the interest rate is too high, we have to answer several questions.

• What is the typical lag between changes in monetary policy, aggregate demand and the price level and how does the real interest rate fit in?

• How long will it take for supply to return to pre-COVID levels ?

• What other tools are available to us for managing inflation and preferably, can we utilise tools which reduce the distress that consumers experience ?

The implementation of monetary policy does not have an immediate effect on consumer and business behaviour.

Because of the delay between a change in the interest rate and aggregate demand, the time it takes for a change in the cash rate to impact the rate of inflation varies between countries, however, estimates for Australia place it between 1-2 years.

It is difficult to place any real estimates on how long it will take for the transmission to take place in Australia, especially when considering the particular circumstances which caused this episode of inflation. With a balance sheet which had ballooned up to three times its value between 2020 and 2021, the RBA must consider how quickly it can raise interest rates in an attempt at quantitative tightening, without causing a shortage in liquidity.

This is an especially important issue to consider as banks will be more immediately responsive to changes in the cash rate than households or businesses are. Through the pandemic, households have built up significant savings buffers and are now spending them, which would further delay the transmission signals of monetary policy. The question of how high the interest rate should rise depends on what is called the real interest rate, which is different to the interest rate which is currently being discussed by commentators. The real interest rate is the difference between the nominal interest rate and the rate of inflation, where the nominal interest rate is the interest seen at a bank for a loan or on a savings account.

When the real interest rate is negative, inflation is higher than the rate of interest, meaning that the value of the loan is in essence being paid off by inflation. As long as there is a negative real interest rate, consumers and businesses will continue to have an elevated demand as they can supplement their consumption by borrowing, reducing the effectiveness of monetary policy. Therefore, the RBA must raise the interest rate until the real interest rate is positive, however, large hikes may not be necessary to achieve this if the inflation rate comes down simultaneously.

Of course, one can argue if supply issues are driving inflation as suggested by the RBA,do we need to wait for supply-side issues to be solved to see a fall inflation. Examining the recent drivers of inflation, the largest driver is domestic holiday travel at 13.3%, followed by electricity at 8.6%, international holiday travel at 7.6% and new dwelling purchases by owner occupiers at 1.7%.

Each of these issues is reflective of a supply side issue, with domestic and international travel capacity still below their pre-pandemic levels combined with the rising cost of jet fuels, whilst demand for travel skyrockets. On the other hand, rising electricity costs are largely reflective of the poor infrastructure dedicated to electricity generation, combined with shortages of the fuels used to power our energy plants. Raising interest rates will not deal with the inflation in these industries where demand is inelastic, instead time must pass for price signals to direct investment such that supply can meet demand.

An ABC article has made the suggestion of increasing the mandatory superannuation contribution during times of inflation instead of raising the interest rate, so that households are able to retain the income instead of just making greater interest payments on their mortgages. This is a genuinely interesting idea, it would reduce aggregate demand and could increase aggregate supply if funds are invested in Australia or in our trade partners.

There are two issues, however, with the ABC article’s suggestion of raising the compulsory contribution rate to superannuation.

First, unlike the cash rate, the superannuation rate is politically determined so unless there is legislation that states how much it rises under a certain amount of inflation, we must wait for the political process to react to inflation. Considering the time lags of monetary policy, the lag between changes in economic conditions and the reaction of the political process would be much greater.

Second, superannuation is taken out of income earnt, not capital gains or transfer payments such as those which occurred during COVID. This means that working age individuals without income from assets or debts which are not indexed with inflation bear the brunt for getting rid of inflation. Whilst enforcing compulsory savings may be somewhat desirable, it would not reduce distress because mortgages will remain indexed with inflation, meaning households are still paying for inflation, we have just increased the ways they must pay for it.

There is no harmless fix for inflation, the interest rate must rise further to dampen demand and this will hurt low income households, however, a further delay will only mean we foot a greater bill down the line.