Let's delve into the intriguing world of economic policy and its potential consequences. The Reserve Bank of Australia's recent move has sparked a debate, and I'm here to share my thoughts on why it might not be the best approach.
The Oil Shock Dilemma
Oil shocks and inflation are complex issues with two distinct scenarios. When excess demand drives an oil shock, as seen in 2007, central banks often respond with interest rate hikes to control demand. However, this argument becomes less convincing when the demand surge originates from external economies.
The second scenario involves a supply curtailment, which typically leads central banks to "look through" the inflation shock. This is a common approach in Australia for events like cyclone damage affecting fruit and vegetable supplies.
RBA's Justification
RBA Governor Michele Bullock defended the rate hikes, attributing them to excess demand in the labor market before the oil shock. But here's the catch: the RBA's own data suggests this excess demand had already been addressed, with employers and consumers backing off, and wages aligning with productivity growth.
In my opinion, the real driver of inflation last year was electricity prices, not wages. Without the oil shock, inflation would likely have eased regardless of the RBA's actions.
Stagflation Nation
Governor Bullock emphasized that households can expect a decline in real income due to the external supply shock. While this is true, the RBA's decision to raise interest rates goes against conventional monetary policy theory. By doing so, they risk further crushing demand and exacerbating the impact on household incomes.
The RBA's forecast of a 1.3% GDP growth next year is concerning. Combined with the oil shock, it could lead to a repeat of the purchasing power decline experienced during and after the Covid era.
This scenario, known as stagflation, is a real possibility, and in my view, the RBA's actions have guaranteed it.
Depressflation: A Worst-Case Scenario
If the war and oil shock persist, we could face a diesel shortage crisis. This wouldn't just mean higher prices; it could mean a lack of diesel to support our agribusiness and mining sectors, as well as food transportation. Rationing would lead to an overnight shutdown of businesses, transforming stagflation into depressflation. Unemployment would soar, wages would plummet, and energy prices would keep inflation high.
Under Governor Bullock, the RBA has abandoned detailed forecasting, relying instead on long-dated data. While forecasting was scrapped due to frequent inaccuracies, driving the economy based on outdated data is risky, especially during sudden shocks and supply crises.
In conclusion, the RBA's decision to hike rates may have been a step towards stagflation, and potentially depressflation if the current crisis persists. It's a bold move, and time will tell if it was the right one. Personally, I think a more nuanced approach considering both demand and supply factors might have been wiser.
