Australia’s economic health: the pressure on interest rates

Inflation and unemployment complicate the RBA’s tightrope walk.

While Australia weathered the pandemic better than many countries, questions about its recovery and handling of high inflation are tempering the economic outlook. Getting inflation and employment settings right will be critical, experts say – and some pain will likely be necessary.

Bruce Preston, Professor of Economics at UNSW Business School, says that while many Australians are facing a challenging period, the economy has managed well in the broader context.  
 
“We had a global pandemic in which we shut down a range of different sectors to protect public health and the economy,” he says. “The idea that we’re going to walk away from that as a society without paying some economic cost is, I think, an overly optimistic one.” 

The Reserve Bank of Australia (RBA) is now facing a critical moment in its bid to engineer a soft landing, with pressing concerns on the horizon.

“I worry that if it turns out the Reserve Bank has been overly optimistic, there’ll be a lot more inflation entrenched in the economy, in people’s inflation expectations, and it’s going to require perhaps some additional interest rate rises that might not have been warranted had they acted earlier,” he says.

Strong recovery, weak growth

The big-picture economic outlook includes continued “relatively lacklustre” growth in Australia’s gross domestic product (GDP), which grew by just 0.2% in the June quarter, says Dr Nalini Prasad, senior lecturer in the School of Economics at UNSW Business School.

“Growth has been subdued as inflation and higher interest rates have reduced demand,” she says. “This has been particularly true for households, with homeowners seeing their mortgage interest rates climb by more than four percentage points and renters seeing noticeable increases in rents. 

“As a result of this, consumption has been weak. Households appear to be reallocating their spending towards essential goods and services – think electricity, health care and rents –  and away from discretionary items – think restaurants and holidays.”

Prof. Preston says Australia’s economic position is clearer in the context of its recovery from the monumental challenges of the COVID-19 pandemic.

“It was a significant macroeconomic development that put a lot of stress on the Australian economy, and I think we handled that particularly well as a nation,” he says. 

Ongoing inflation concerns

While inflation has been cooling in Australia, the process has been slow, with the Consumer Price Index hovering above the RBA’s target band of 2-3% for three years. The RBA now expects inflation to reach the top of the band at the end of next year.

Should inflation keep falling, the RBA will likely keep the cash rate unchanged for the rest of 2024 until it has more information about the state of the economy, Dr Prasad says.

However, there’s an important question, and now a public debate, over to what extent the RBA’s goals are feasible, according to Prof. Preston.

“The bank is in a challenging place: inflation’s high, but the labour market is very robust, and that’s something to celebrate,” he says.

Nonetheless, labour market outcomes reflect the level of demand for goods and services, and based on recent data, the RBA has judged that there is still excess demand.

“I think they’re alert to the fact that perhaps the current state of the labour market is unsustainable and are worried about how to manage that,” Prof. Preston says. 

“It will require slowing the economy to ensure that demand declines by some amount to be consistent with current supply conditions,” he says. “A lot of the debate is about, well, what kinds of interest rate rises would be required to bring that situation about?” 

Labour market tightness

Meanwhile, unemployment in Australia is maintaining historically low levels, although July figures showed the unemployment rate continuing a slight upward trend to 4.2%. 

“While the labour market is still tight, there are small signs that there might be some loosening in the future, with job advertisements and vacancies coming down,” says Dr Prasad. A looser labour market would help to cool inflation, but this is unlikely without higher unemployment that would, in turn, lead to lower prices and wage growth.

As Prof. Preston pointed out, another concern stems from people’s perceptions of how they’re doing, which are not positive. “Not surprisingly, that reflects the fact that rising prices reduce the purchasing power of household budgets and makes people feel poorer,” he says. 

“Despite the very strong health of the Australian real economy, at the end of the day, the ability to have stable inflation depends on a balance of supply and demand. My sense is that these very low levels of unemployment are probably inconsistent with long-run stable inflation.”

Prof. Preston says these challenges illustrate the RBA’s difficult path to achieving its goals of sustainable inflation and full employment. 

“My view is, to the extent that there’s still evidence of a situation of excess demand, the bank probably hasn’t done enough, and that some additional interest rate rises will be required,” he says. “It’s a bit of a gamble on an unexpectedly good outcome, and I worry that if faced with a bad outcome, interest rates might have to be increased by even more than some other countries have done.”