RBA ready to shift up a gear as the neutral rate rises
A Central Bank official said the Iran war could raise the “neutral” interest rate level and require further interest rate hikes to control inflation.
The RBA must keep inflation expectations in check as conflicts in the Middle East send oil prices and economic uncertainty through the roof, deputy governor Christopher Kent said on Thursday.
Inflation data released by the Australian Bureau of Statistics a day earlier confirmed the central bank’s assessment that domestic conditions were too tight even before the start of the war.
Although headline inflation fell from 3.8 percent to 3.7 percent in February, economists predict that the consumer price index could exceed 5 percent by June as the second-order effects of higher oil costs spread throughout the economy.
Markets expect the RBA to respond by increasing interest rates at least twice more, following increases announced by Governor Michele Bullock in February and March.
But how much the bank should raise the cash rate depends on the neutral rate, which is the theoretical interest rate at which inflation will remain constant.
Dr Kent said turmoil in commodity and other markets had led to a tightening in financial conditions, which, all else being equal, pointed to a fall in short-term neutral interest rates, meaning interest rates would not have to be raised as high to have the same effect.
“But the supply shock also poses a risk to inflation and long-term inflation expectations at a time when capacity pressures remain in Australia and some other advanced economies,” he said at the KangaNews Debt Capital Markets Summit in Sydney.
“This could both push up short-term neutral interest rates and require a more restrictive policy stance.”
The longer the war lasts, the greater the economic impact will be and the greater the risk of a market sell-off, he said.
Although the energy crisis risks slowing the economy and higher interest rates could worsen the downturn, Dr. Kent reiterated the bank’s determination to keep inflation under control.
“A negative supply shock raises prices and weakens economic activity, making us all poorer,” he said.
“Central banks cannot change this. But they can ensure that the initial rise in prices does not lead to an increase in long-term inflation expectations and a prolongation of inflationary pressures.”
The government is also trying to combat the impact of the protracted war on the Australian economy.
Treasury Secretary Jim Chalmers said Wednesday that the Treasury is modeling two scenarios for the economy in which oil prices remain at $100 a barrel for a short period of time or rise to $120 a barrel for a longer period, both of which look “pretty conservative right now.”
The benchmark Brent crude oil price was just under US$100 per barrel on Wednesday amid conflicting claims about peace talks between the US and Iran.
Dr Chalmers said the Treasury was studying “some more challenging conditions” but the modeling was not yet complete.
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