The Reserve Bank of Australia's recent decision to hike interest rates, in my opinion, is a misstep that will likely exacerbate economic woes rather than alleviate them. This move, particularly in response to an oil price shock, strikes me as a textbook example of applying the wrong medicine to the ailment. It’s a situation where the central bank appears to be navigating by looking solely in the rearview mirror, a dangerous strategy in today's volatile economic landscape.
The Two Faces of Oil Shocks
When we talk about oil price shocks, there are fundamentally two scenarios, and the appropriate response differs dramatically. Personally, I think it's crucial to distinguish between them. One scenario is when oil prices surge due to overwhelming global demand. In such cases, where the economy is red-hot and straining resources, a central bank's decision to raise interest rates to cool demand makes intuitive sense. It's a way of saying, 'We need to slow things down because we're running out of stuff.' The argument here, even if demand originates elsewhere, holds some water because any nation participating in the global market contributes to that demand.
However, the second, and in my view, more relevant scenario for the current situation, is when an oil price shock stems from a curtailment of supply. Think of it like a sudden frost damaging a fruit crop; the immediate impact is a reduction in availability, driving up prices. In these instances, the conventional wisdom among monetary economists, and something I strongly agree with, is to "look through it." This means accepting the temporary price increase as an external shock that will naturally temper demand because consumers will simply have less disposable income. Australia has historically done this with other supply-driven price hikes, like those affecting produce after severe weather.
Misinterpreting the Inflationary Signals
What makes the RBA's recent actions particularly concerning is their stated justification. Governor Michele Bullock has emphasized that the rate hikes weren't solely due to the recent oil shock but rather to "excess demand" that predated it, evidenced by a tight labor market. From my perspective, this narrative doesn't quite hold water when you examine the data. The RBA's own charts, as far as I can tell, show that this supposed excess demand had already been significantly curbed. Employers were showing signs of fatigue, consumer spending was cooling, and wage growth was aligning with productivity. The idea that the inflation rebound was driven by wages, rather than external factors like electricity prices and the oil shock, seems like a convenient, albeit inaccurate, simplification.
If we're being honest, and this is a point I feel is often missed, even without the oil shock, inflation would likely have subsided on its own by 2026. The RBA's intervention, therefore, feels like pouring fuel on a fire that was already burning itself out.
Guaranteed Stagflation
The governor did correctly point out that an external supply shock like an oil price increase will inevitably make us poorer, denting our real incomes. This is an undeniable truth. However, what she seemingly overlooked, or perhaps chose not to emphasize, is that this real income shock is precisely why raising interest rates is the wrong move. The shock itself is already acting as a drag on demand. By tightening monetary policy further, the RBA is essentially ensuring that demand is not just dampened, but utterly crushed. This, in my opinion, is a recipe for stagflation – a nasty combination of stagnant economic growth and high inflation.
The RBA's own forecast of GDP falling to a mere 1.3% next year, which is practically stall speed for an economy, combined with the ongoing oil shock, paints a grim picture. It suggests a repeat of the purchasing power destruction we experienced during and after COVID, where wages simply can't keep up with rising prices. This isn't just a possibility; in my view, the RBA has effectively guaranteed it.
The Specter of Depressflation
Looking ahead, if the current geopolitical situation and oil shock persist, we could be staring down the barrel of something even more severe: "depressflation." This isn't just a theoretical concept; it's a potential reality where shortages of critical resources, like diesel, cripple key sectors such as agriculture and mining. Imagine businesses shutting down overnight, not because they can't afford to operate, but because they simply can't get the fuel. This would lead to skyrocketing unemployment, plummeting wages, and stubbornly high inflation driven by energy prices. It's a truly terrifying prospect.
Driving Blind
One of the most disheartening aspects of this situation is the RBA's apparent abandonment of forward-looking economic forecasting. They've opted to steer the economy based on historical data, essentially driving in the rearview mirror. While I understand the rationale – they've been wrong in the past – in a world characterized by sudden supply-side crises and external shocks, this approach is far more perilous. It risks policy decisions being made at precisely the wrong moments, exacerbating downturns instead of mitigating them.
It offers little comfort, but the fact that one dissenting vote was cast against the rate hike suggests there's at least a glimmer of hope for more sensible policy in the future. Perhaps, over the long term, the bank can indeed be reformed. For now, however, I fear the damage from this decision is already baked in.
