There has been a growing push to persuade the Reserve Bank of Australia (RBA) to reduce interest rates. However, RBA Governor Michele Bullock has several reasons to remain cautious, despite the recent decline in trimmed mean inflation to 3.2%. Given the progress in controlling inflation, it would be prudent to adopt a conservative approach. Despite facing criticism for its previous rate hikes, prematurely reversing those measures could undermine the central bank’s efforts before inflation fully stabilizes. Moreover, as both federal and state governments increase their budget deficits, they are already loosening fiscal policies. With an upcoming election, further government spending and financial incentives are anticipated. The experience of the United States demonstrates that tight monetary policy combined with expansionary fiscal measures can sustain economic growth. However, a concerning trend in Australia is that most employment growth has occurred in the public sector, while the private sector remains stagnant.
Domestic Inflationary Pressures
The RBA primarily influences services inflation, or more specifically, the prices of non-tradable goods and services determined by domestic supply and demand. These costs continue to rise at a rate of 4.3%, which aligns with domestic unit labour cost growth of 5%. Such a level is unsustainable and is not driven by excessive wage increases but rather by declining productivity.
Additionally, the overall reduction in inflation has been largely driven by a mere 0.8% increase in goods inflation (mainly tradables) over the past year. Global markets influence these prices, making them beyond the RBA’s direct control. The central bank can only exert a limited influence through exchange rate adjustments, and a rate cut would likely weaken the Australian dollar, thereby increasing the cost of tradable goods. Relying on continued declines in global prices to bring overall inflation within the target range is risky, particularly given the uncertainty surrounding the potential economic policies of the United States under President Donald Trump. Until the global outlook becomes clearer, lowering interest rates prematurely could stall the necessary deceleration of domestic non-tradables inflation.
Political Pressure and Economic Fundamentals
With an election approaching, there is political interest in securing an early interest rate reduction. However, such a move carries the risk of allowing domestic inflationary pressures to remain elevated. Wage increases continue to be a focal point, particularly within the public sector, and productivity remains alarmingly low. Unit labour costs are projected to grow at a pace that would make it difficult to bring domestic non-tradable inflation within the target range unless global inflation remains unusually low.
Currently, the wage price index is rising at 3.5%, with an additional 0.5 percentage point increase anticipated due to the upcoming rise in the superannuation guarantee. Given the ongoing decline in productivity, these factors create a significant barrier to reducing inflation to a sustainable level. Moreover, employment continues to expand, and increased fiscal stimulus suggests that the economy is not on the brink of recession. If employment were to decline significantly, there would be a stronger justification for reducing interest rates. However, in the current environment, such action appears premature.
Additionally, public sector wage demands remain high in major states, and recent legislative changes aim to extend higher wage rates to contractors and casual employees without corresponding productivity gains. If inflation remains persistently above the target range, another round of monetary tightening may become necessary, reversing the progress achieved thus far.
A Sustainable Economic Strategy
Rather than artificially stimulating demand through early interest rate cuts, the government should prioritize policies that enhance supply and improve productivity. This approach would provide a more sustainable path out of the current economic stagnation, where per capita income is declining while inflation remains elevated. Ultimately, the decision rests with the RBA, but the rationale for an immediate rate cut remains weak. Political considerations should not dictate monetary policy unless the economic case is compelling, which at present, it is not. The RBA governor should maintain a firm stance and continue prioritizing long-term economic stability over short-term political pressures.
The government may take credit for the recent decline in inflation, but there is no urgent need to reduce interest rates at this stage. Prudent monetary policy requires careful assessment of economic conditions rather than reactive measures driven by external pressures. By maintaining a cautious stance, the RBA can ensure that inflation remains on a downward trajectory without jeopardizing the hard-earned gains achieved through previous policy actions.