The Reserve Bank of Australia has hiked its interest rate 4 times so far this year, for a combined total of 1.75 percentage points. And it has signaled more increases are ahead, as it joins other central banks around the world in rapidly increasing rates to slow spending power, job-creation, and hence inflation.
In this commentary, Centre for Future Work Associate Dr Anis Chowdhury challenges the wisdom of this strategy. Since current inflation is related more to supply chain disruptions and other global pressures, higher interest rates will do more harm than good -- and shift national income even further toward the owners of capital, instead of working Australians.
Interest Rates Hikes Will Hurt Workers to Protect Profits
by Dr Anis Chowdhury
The Reserve Bank’s latest interest rate hike, the fourth in a series and with more to come, will certainly slow economic activity and raise unemployment. It will hurt families, especially of the working class, who played no role in the current bout of inflation.
Treasurer Jim Chalmers warned Parliament, “Families will now have to make more hard decisions about how to balance the household budget in the face of other pressures like higher grocery prices, and higher car prices and the cost of other essentials”.
This is bad news, especially since many will also lose their jobs as the economy slows.
But it didn’t have to be like this – had the RBA and other policy-makers cared to seriously consider what is driving inflation, and been less dogmatic about their inflation target and how to reach it. Many seem to have forgotten the Labor Government’s own successful experience of addressing inflation in the 1980s through social dialogue, reducing price pressures without causing unemployment to rise. Those lessons should be relearned today.
What is driving current price rises?
The primary source of current price pressure is not surging demand, soaring wages, or a household spending spree fueled by pent-up demand and one-off pandemic financial supports. Indeed, as RBA Governor Philip Lowe has acknowledged, “The household saving rate remains higher than it was before the pandemic and many households have built up large financial buffers”.
Even the labour market tightening and skills shortages seen in some sectors are not the result of surging aggregate demand, but rather mostly due to the impacts of the pandemic on labour supply (including via restrictions on the inflow of migrant workers).
Instead, the primary driver of current inflation is supply bottlenecks and blockages of goods, caused by a perfect storm of global problems: the pandemic, the war in Ukraine, and climate change’s effect on agricultural supply (and hence prices of food).
Interest rate hikes cannot fix supply bottlenecks; instead, they will exacerbate supply problems, by discouraging investment in new capacity and infrastructure. Interest rate hikes will also impose collateral damages on government finance, in addition to causing job losses and economic hardship for struggling families.
The Treasurer’s warning to brace for bigger real wage cuts than previously flagged is no comfort for the ordinary workers who already saw their income share in GDP steadily decline during the past four decades – while the share of GDP going to capital owners in profits continued to rise, setting record highs during the pandemic.
A recent report from the Australia Institute found that rising prices in Australia are actually driving corporations’ profits to record highs amid a cost-of-living crisis for the rest of us. This has been enabled in large part by lack of competition. Big corporations in energy, transportation, supermarkets, and other sectors use their oligopolistic power to raise prices (and profits) far above what would be necessary simply to cover higher input costs.
A recent study published in the UNSW Law Journal documented widespread price gouging in Australia: “a notorious practice” involving “pricing high-demand essentials at levels significantly higher than what is commonly considered acceptable, reasonable or fair”. During recent crises, including the Black Summer bushfires and then the COVID pandemic, unethical businesses exploited public desperation for basic consumer goods and services, such as hygiene products, staple foods, and utility services, to raise their profit margins.
Why raise interest rates?
The RBA knows it cannot fix supply shortages. Yet still it raises the interest rate, calls it a “forward-looking” strategy, and claims it will stem inflationary expectations and higher wage demands. Basically, this is a tactic to scare workers: in essence, saying to workers they must not ask for compensating wage gains or for restoring their share of domestic income, lest the Bank inflict more pain through losing jobs and livelihoods.
Central bankers around the world sugar-coat this scare tactic by saying, “It’s short-term pain for long-term gain”. That’s easy for them to say, as no central banker ever lost his/her job for such actions, or have tasted this “short-term pain” (which can actually affect a worker and their family for decades via lost work and suppressed incomes).
This view also ignores the fact that labour’s bargaining power has significantly declined compared to previous inflationary episodes, due to the erosion of collective bargaining and other institutional supports for wages, new technology, out-sourcing and globalisation. All these factors have driven the steady declines in labour income share and real wages. They also mean that fears of a 1970s-style “wage-price spiral” are not credible.
The interest rate: a blunt tool
The dogmatic stance of central bankers will cause more damage than it avoids. Even when inflation is rising, higher interest rates are not the right policy tool to tackle the problem for several reasons.
First, the interest rate only addresses symptoms, not the root causes, of inflation. Inflation is often understood as the overheating of an economy. Like a fever, overheating of an economy can be due to many causes – fever and overheating are just symptoms. Interest rates, like Panadols or Aspirins, may relieve the overheating, but the treatment requires investigations into the root causes and appropriate medications.
Second, changes in the interest rate affect all sectors – without distinguishing sectors that need expansion and hence credit support, from sectors that are less productive or inefficient and hence should be credit-constrained. Just as taking too many Panadols or Aspirins can have fatal side effects, hiking interest rates too often and too high can kill productive and efficient businesses along with less productive and inefficient ones.
Third, the overall interest rate does not distinguish between households and businesses. Higher interest rates may encourage households to save, but will dampen business capital spending. Thus, overall economy-wide demand will shrink, discouraging investment in new technology, plant and equipment as well as skill-upgrading. Thus, higher interest rates adversely affect the long-term productive capacity of an economy.
Fourth, higher interest rates will raise the debt burden for governments, business and households. Global debt burdens have been on the rise since the 2008-2009 global financial crises, and even more dramatically during the COVID crisis. Those debts (especially sovereign government debts) are manageable so long as economic growth remains robust and interest rates low. Current monetary policy, however, will negatively affect both factors: raising rates and slowing growth. That could set the stage for debt problems down the road.
Monetary tightening will have implications for fiscal policy, too. A slower economy implies less tax revenues and more social security payments. Government is already under pressure to continue pandemic support measures, such as financial assistance for workers without paid sick leave as well as cost-of-living supports. Planned Stage Three tax cuts, if they go ahead, would further undermine Commonwealth government revenues. For state governments, heavily reliant on stamp duties, a collapse of the housing market would devastate their budget bottom-lines.
Paradoxically, higher interest rates can even feed into higher costs of living, as indebted households’ debt-servicing costs (especially on mortgages) rise. The cost of living would also rise if businesses with market power pass on their own higher interest costs to consumers through still higher prices.
As mentioned earlier, the current inflationary surge is due to supply shortages of key products, such as food and fuel. Therefore, the long-term solution requires expansion of supply and removal of bottlenecks. Perversely, however, higher interest rates force overall demand to shrink down to match aggregate supply. That can slow price increases, but leaves underlying supply constraints for key products unaddressed – hence not addressing the underlying causes of inflation.
Therefore, policymakers should consider innovative and more appropriate policy tools to respond to current price pressures. The focus of anti-inflationary policy should be changed radically from suppressing domestic demand to enhancing supply and productivity; from restricting credit indiscriminately to easing financing constraints for key and ‘sun-rise’ industries (e.g., renewable energy) while tightening financial conditions for inefficient (e.g., polluting) and speculative activities (e.g., real estate).
This would mean designing macroeconomic policies to support industrialisation and economic diversification. Instead of reacting to inflationary symptoms with a lone blunt policy tool (the interest rate), policymakers should wield a mix of fiscal and monetary policy levers: using them to unlock supply bottlenecks, enhance productivity, and encourage savings and productive investments (especially to decarbonise the economy).
Each of these goals needs innovative and customised policy tools, rather than a one-size-fits-all reliance on interest rates to throw cold water over the entire economy.
Inflation and responses to it inevitably involve social conflicts over economic distribution. The ‘social dialogue’ approach of Labor Prime Minister Bob Hawke contrasted with the more confrontational approaches of Margaret Thatcher and Ronald Reagan – and their deliberate use of punishing interest rates to inflict long recessions in the 1980s.
In contrast, social dialogue in Australia not only brought down inflation and unemployment simultaneously in the 1980s, but also enabled difficult reforms – including floating exchange rates and lower import tariffs. That set the stage for sustained economic growth in years to come.
The new Labor Government needs to earnestly begin rebuilding that model of social partnership to confront not only current inflation challenges, but the more existential threats of climate change and shifts in the global order.
The government must also not miss the opportunity to review the RBA’s mandate and operations, including better balancing its board with a more representative variety of stakeholders (including workers). The economy does not work in a vacuum, and should not be entrusted to technocrats. Policies and reforms affect real lives and livelihoods. The RBA needs to understand, and hear, the voices and preferences of all Australians, not just financiers and employers.