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Economics
Does raising rates really cut inflation?
September 04, 2008
Clifford Bennett, Chief Economist, Sonray Capital Markets

The fluctuations of global oil prices are the primary driver of inflation, not just in Australia, but globally. A comparison of central bank policies against inflation rates, shows how different policy settings still ended up with a similar inflation outcome. The conclusion can only be that central banks generally, and the RBA in particular, need to reassess their approach to monetary policy.

The RBA hiked rates from 6.25% in Q3 2006, to a peak of 7.25%. During this period, and despite the already existing extremely high by global standards rate settings, inflation increased by 137% from 1.9% to 4.5%. Their argument might read, see we had to raise rates because inflation was rising. That’s interesting, but let’s take a look at the US experience. During the same period the Fed cut rates from 5.25% to 2.00%, the inflation outcome was an increase of 107%, from 2.7% to 5.6%. In other words a reduction by the Fed of some 325 points produced a superior inflation outcome to that of the RBA’s increase of 100 points. The counter argument is of course that slowing US demand helped the inflation outcome, but Australia has been experiencing the same slowing demand, Australian GDP is expected to be 2.9% tomorrow according to consensus forecasts, getting close to the US at 2.2%.

Of course it can become a circular argument, growth/rates/inflation, but a look at the monetary policy of the UK, US, Eurozone, and Australia, with their disparate approaches over the last twelve months, shows all experienced inflation increases of 90% to 137%. The stand out observation is that the economy with the highest settings had the highest inflation growth, while the economy with the most stable rate policy, the ECB only acted once moving rates from 4.00% to 4.25%, had the smallest increase in inflation, 90%. It can be strongly argued that inflation rates have been determined by oil prices, and not central bank policy. During this period, while inflation in these economies increased by 90% to 137%, the price of oil increased by a very similar 135%.

It remains my view that rate increases in response to an energy price shock, are entirely inappropriate in this era of true competitive pricing pressure. Natural competition nowcontains inflation, not central banks. Increasing rates only adds to the weight of higher energy prices, resulting in un-necessary recessionary risks. Inflation has peaked and will decline as a result of the reversal in oil prices. Oil price stability will allow the RBA to continue to correct past mistakes, and should see the cash rate at 6.50% in early 2009.

The RBA has done a good job of slowing the economy, but for what purpose?

Clifford Bennett, Chief Economist, Sonray Capital Markets.

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