As the RBA attempts to keep inflation and unemployment rates low, it faces a tricky challenge. Here’s what to know about what might happen next.
Keeping Australia’s economy healthy requires a difficult balancing act.
The Reserve Bank of Australia (RBA) needs to keep inflation low and stable, while also keeping the economy at full employment.
But price inflation has been growing above its target band of 2-3% since mid-2021.To seek to bring this under control, the RBA has increased interest rates.
That has meant a higher unemployment rate. Higher interest rates are also leaving many Australians feeling the pinch as they struggle to pay their mortgages.
The questions on many people’s lips are what might happen next with interest rates, what will happen to unemployment — and are there better ways for the RBA to manage inflation, employment and interest rates?
Low inflation, low unemployment: Two key RBA goals
The RBA’s first objective, keeping prices low and stable, means ensuring the annual rate of growth in prices (the Consumer Price Index) stays within a target range of 2-3% each year.
Keeping to this target is seen as an important way to promote economic growth. When price inflation becomes either too high or too low it can disrupt, and act as a drag on, economic activity.
The RBA’s second goal, achieving full employment, means “everyone who wants a job should be able to find one without searching for too long”.
Full employment doesn’t mean an unemployment rate of 0%. It is always going to take time for people looking for work to apply for jobs and be hired; and sometimes jobseekers will need to move locations or get new skills to find work.
Still, getting to full employment is an important objective to have because it means we are using our available workforce to the maximum extent possible. That in turn maximises Australia’s national output and our overall living standards.
Having more people working also improves equity, increasing incomes for people who would otherwise be unemployed. The groups who benefit most are those who face the biggest difficulty getting into work, such as lower-skilled workers, the young and people living in disadvantaged regions.
Price stability and full employment — with the benefits they bring — seem eminently sensible objectives for our policymakers to aim for. “Go for it”, we might think.
But there’s a catch: Sometimes it can be difficult, or even impossible, to achieve both objectives at the same time. And, at the moment, we are in one of those times.
Why rising inflation prompted RBA action
Around mid-2021 in Australia, price inflation began to rise. A similar surge in inflation was seen in other countries too following COVID lockdowns, especially in developed economies.
By mid-2022, price inflation had moved well above the target range, causing the RBA to react.
The way the RBA seeks to control high inflation is by slowing the ‘demand side’ of the economy, consumer spending and business investment. And the way it can do that is by increasing what is known as the ‘cash rate’ — the interest rate on unsecured overnight loans between banks.
Raising the cash rate causes banks and financial institutions to increase other interest rates, such as on home loans. That’s just what happened after the RBA began raising the cash rate in mid-2022 — mortgage repayment costs jumped.
Home loan (and other) borrowers who find themselves with higher repayments have less income for spending on items such as food, healthcare and entertainment. Higher interest rates also make it more expensive for businesses to borrow, increasing their costs of operating.
An unfortunate side-effect: Rising unemployment
Slower employment growth is the next outcome from higher interest rates. With households spending less and businesses finding conditions more difficult, demand for labour falls.
In Australia, employment growth has slowed notably since the RBA started increasing the cash rate in May 2022. Annual employment growth in 2022 was 4.1%, but in the year to August 2024 had slowed to just 2.6%.
With lower employment growth, the rate of unemployment is likely to rise. That has also happened. Since June last year the rate of unemployment has risen from 3.5 to 4.2%.
The higher unemployment we have seen in Australia over the past year is therefore an unfortunate cost of the RBA’s policy of raising interest rates to seek to control inflation.
The RBA has, however, tried to keep the increase in unemployment as small as possible while it brings down inflation — walking what former Governor Philip Lowe described in a speech in mid-2023 as ‘the narrow path’.
To put things in perspective, Australia has increased interest rates less than other countries such as the US, UK and Canada. The benefit has been that, so far, we’ve had a smaller increase in the rate of unemployment than those countries, even while the proportion of the population looking for work has risen.
So that’s where we were up to in the middle of 2024.
Since then, three questions about interest rates and full employment are increasingly being asked.
When should the RBA start lowering interest rates?
Opinions on this vary depending on views on the current strength of the economy and labour market, and the relative weight that should be attached to the price inflation and full employment objectives.
Thus far, the RBA has argued that fighting inflation remains the priority and that the labour market is still in good shape — and therefore interest rates need to remain at their current level.
But the statement by RBA governor Michele Bullock following the September board meeting, that for the first time a further increase in interest rates was not discussed, is a sign its opinion may be changing.
When the RBA lowers interest rates, what is the ‘full employment rate’?
Opinions differ on this too. The RBA and Treasury estimate full employment at present to be a rate of unemployment of around 4.25-4.5%. That is the rate they think we could get unemployment down to without causing wage growth to become so high as to push price inflation outside the target range.
But some economists think it’s likely we could get the rate of unemployment lower, perhaps to 3.5%, without it conflicting with price stability.
Are there better ways of managing demand in the economy?
Any policy that has the objective to restrict growth in the economy is always going to cause extra unemployment, so there’ll always be a trade-off between the price inflation and full employment objectives.
But interest rate policy brings other problems — such as the costs that home loan borrowers bear (while those with savings benefit).
That, together with limitations such as uncertain timing and size of impact of interest rate policy, have led to suggestions that we need to find other ways to deal with inflation.
Economics journalist Ross Gittins, for example, has suggested that superannuation contributions could be varied when the government wants to increase or decrease demand in the economy.
Another idea is to move the GST rate up and down, as a way of restricting or stimulating demand.
Jeff Borland's main research interest is analysis of the operation of labour markets in Australia.
Originally published under Creative Commons by 360info™.