Today’s rate
increase has nothing do with bananas. It reflects the fact that the Reserve Bank
needs to exert further restraint on the growth of domestic spending in order to
prevent the cost increases which businesses have been facing for some time now
from being passed on to consumers in the form of higher prices for goods and
services on a sufficiently widespread basis that “underlying” inflation exceeds
the Bank’s 2-3% target range for an extended period. Last week’s June quarter
CPI release suggested that has already begun to occur.

The risk of a
sustained acceleration inflation is rising because the Australian economy, after
nearly 16 years of more or less continuous economic growth, is now bumping up
against “capacity constraints” (particularly in the labour market and with
regard to infrastructure), which is generating rising costs; while strong growth
in demand is creating the circumstances in which businesses can pass those
higher costs (and other rising costs such as energy and transport) on to their

The Reserve
Bank’s task in keeping underlying inflation within its target is being
complicated by two factors. First, the China-driven surge in minerals and energy
prices which is boosting national income by more than one percentage point per
annum. And second, the Federal Government’s fiscal policy, which – by
transferring windfall revenue gains reaped from mining companies to households
in the form of large tax cuts and increased cash benefits, at a time when it should
instead be “saving” those windfalls in the form of bigger budget surpluses – is
now pushing in the opposite direction to monetary policy.

In other words, the Australian economy is in danger of exceeding
its inflation “speed limit” in circumstances where the costs of doing
so are rising. To prevent that happening, the Reserve Bank is
trying to step gently on the brake. But because someone else – the
Government – has its foot on the accelerator, the Reserve Bank has to
push harder on the brake than might have been necessary otherwise.

Today’s rate rise
will take cost household borrowers another roughly $2 billion per annum, in
total, in higher interest payments – on top of the $2 billion cost of May’s
increase. The rise in petrol prices over the past few months is costing
households a further $1 billion per annum (according to Access Economics). But
adding all this up still falls well short of the nearly $9 billion per annum
boost to household incomes from the tax cuts which took effect on 1 July – which
helps explain why the May rate increase has had so little impact thus far,
and provides one reason why the Reserve Bank now perceives a need to raise rates

Today’s rate
rise probably will slow demand a little, and may make some marginal would-be
home buyers think again. Consumer confidence will take a short-term hit,
especially if this Friday’s more detailed quarterly statement from the RBA
carries the message that rates could rise again this year (as it might).
Employment has been surprisingly strong over the two months since the last rate
rise, so it wouldn’t come as any shock to see slower jobs growth over the next
few months. Equity markets will probably take the announcement in their stride,
since it’s been universally expected at least for the past week. The impact on
business investment should be pretty marginal, since most business investment is
financed by internally generated funds, not by debt.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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