The Reserve Bank of Australia hopes taking swift action on soaring inflation will halt the need to increase the cash rate as high as previous economic cycles.
Speaking at the Australian Strategic Business Forum 2022 in Melbourne, Governor Philip Lowe said the board was prepared to act quickly to get inflation under control and avoid a repeat of the 1970s.
With the Consumer Price Index (CPI) sitting at 5.1 per cent, Australia currently had the highest level of inflation since 1991.
While this is lower than most other major economies, it was still higher than the board expected, Dr Lowe said.
“The path back to 2–3 per cent inflation requires an increase in supply and some moderation of demand,” he said.
“For inflation to return to the 2–3 per cent target range, a more sustainable balance between demand and supply is needed.
“Higher interest rates will help achieve this through moderating growth in aggregate demand.”
Dr Lowe said many of the factors that had contributed to higher prices, such as supply chain issues and COVID policies, were starting to ease, but headwinds like the war in Ukraine remained.
“With the Covid emergency now over, so too is the time for emergency settings of monetary policy,” he said.
“The RBA was patient in withdrawing the insurance that was put in place during the pandemic.
“We wanted to ensure a robust recovery and we were very aware that our main policy instrument – the cash rate – was at the effective lower bound.
“That robust recovery has taken place and the time for ultra-low interest rates is now behind us given that inflation is high and the labour market is very tight.”
In light of the current level of inflation, the Reserve Bank Board has increased the cash rate 125 basis points over the past three meetings to 1.35 per cent.
Dr Lowe expects further increases in the months ahead, but stopped short of predicting where the cash rate would end up.
He suggested a neutral rate would be about 2.5 per cent.
“If we take the 2.5 per cent midpoint of the inflation target as a reasonable estimate of medium-term inflation expectations, this suggests that the neutral nominal rate is at least 2.5 per cent,” he said.
“It would be higher than this if medium-term inflation expectations were to shift higher.”
Dr Lowe said it was prudent the RBA acted quickly and aggressively on interest rates to avoid a situation similar to the 1970s, when inflation became ingrained into the psychology of consumers and businesses.
“If inflation expectations shift up and businesses and workers come to expect higher rates of inflation on an ongoing basis, it will be harder to return inflation to target – doing so would require higher interest rates and a sharper slowing in spending,” he said.
“It is in our collective interest that this does not happen.”
As well as tackling inflation, Dr Lowe said Australia needed to do more to encourage productivity growth.
“Recent trends in productivity growth have not been particularly encouraging, with average productivity growth slowing,” he said.
“Over the decade to 2014, labour productivity growth averaged 1.2 per cent per year; over recent years, it has been slower than this.
“In contrast, labour productivity growth was in excess of 2 per cent during much of the 1990s.”
Dr Lowe said the underlying reasons were complex and not well understood.
“The strategic challenge for us as a nation is to do what we reasonably can to lift our productivity growth,” he said.
“The good news here is that there is no shortage of ideas on how to do this.”
Dr Lowe also said the use of technology could change the way society used money.
“On the horizon is the possibility of programmable money, which contains self-executing code that triggers a payment when a specified condition is satisfied,” he said.
“Also on the horizon is the potential tokenisation of bank deposits, which could facilitate the tokenisation of other physical and financial assets.
“This, in turn, could unlock a wave of innovation and productivity growth across financial services.”