If Australians don’t have faith in the Reserve Bank’s promise of a “narrow path” to avoid recession, they could end up being the cause of one, the central bank’s governor Philip Lowe has warned.

If people start worrying that the path back from five per cent inflation to a more normal level is unrealistic, it might push the economy into a downward spiral, he says.

“There is a path to have inflation come down without the economy having too much pain, but it’s a narrow path,” Dr Lowe told a central bankers meeting in Zurich on Friday.

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“But if people start to worry that we can’t show that credible path back … to two to three per cent inflation … then I think that shift in psychology could be quite persistent. And we know where that ends – it ends in persistent inflation and then you’ve got to have much higher interest rates and an economic downturn to get inflation back down.”

If people are confident in inflation being at or returning to normal levels, businesses do not feel the need to push up prices and employees do not feel the need to push for wage increases, he explained.

But over the past couple of decades, there has been a shift in “inflation psychology” with both businesses and employees showing more willingness to push for change.

“You can understand why people faced with high inflation want compensation for it – especially when the unemployment rate is as low as it is,” he said.

Dr Lowe said the current high rate of inflation is the result of a better-than-expected COVID-19 bounce-back in the economy, persistent supply chain issues and the war in Ukraine.

“If you put them together … it’s not surprising inflation is so high and the challenge we all have is to bring it back down as painlessly as we can,” he said.

But the Australian economy was showing remarkable resilience, he said.

‘I’m not expecting there to be a recession … but there are risks,” he said.

Dr Lowe said he stood by his predictions that inflation would reach seven per cent by the end of the year, before easing off in the first quarter of next year.

Factors contributing to that assessment included temporary relief from some government taxes ending in December; COVID-related problems in the economy showing signs of resolution; the unlikelihood of seeing another dramatic hike in fuel prices; and higher interest rates constraining some spending.

“So we’ve got four things together that give us confidence inflation will start trending lower next year. That’s not to say we won’t get another shock, but they’re pretty powerful influences,” he said

“The question we’re now grappling with is how fast the decline in inflation will be.”

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Peter Fray
Peter Fray
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