Rate hikes won’t fix inflation caused by fuel prices

The inflation figures released today confirm what we already know: inflation is up, and it’s all because of higher fuel costs.

The March figures confirm that none of the inflation has flowed through to other parts of the economy. An astonishing 90% of the monthly increase was from automotive fuels alone. In fact, if automotive fuels had not increased, annual headline inflation would have been lower than the previous month.

This was confirmed by the Australian Bureau of Statistics (ABS) measure of underlying inflation, called the trimmed mean. It was unchanged from the previous month at 3.3%. The trimmed mean has now been steady on 3.3% for the last four months.

But why is this important?

It is important because we need to disentangle what is causing the increase in prices. If the price increases are caused by excessive demand, then increasing interest rates can help lower that kind of inflation.

But if the increase in prices is caused by a supply shock, then interest rates are ineffective at lowering inflation.

The data is clear: the increase in inflation is from a supply shock. None of it is being driven by demand, and increasing interest rates will just heap more pointless pain on Australian households.

Interest rate increases act on demand. If people are paying more on their mortgages, they have less money to spend on everything else. If businesses see less demand, they will need to compete harder to sell all their stuff. In this environment, they will be less likely to increase prices.

But if the inflation is caused by higher fuel prices, higher interest rates will do nothing to bring those prices down. No matter how high Australian interest rates go, it will have no impact on opening the Strait of Hormuz.

Higher fuel prices also act to reduce household demand. If people are spending more on fuel, then they have less to spend on everything else. Less spending means slower economic growth.

If interest rates go up, on top of higher fuel prices, this will further slow spending and economic growth. The economy is then at risk of stalling and possibly entering a recession.

After the latest inflation figures were released, the market thought that an interest rate rise was slightly less likely. But still gives it about a 75% chance of rates going up.

There is a real chance the Reserve Bank of Australia (RBA) increases rates next week, even if the evidence says they shouldn’t.

The RBA sees itself as the one organisation that needs to fight inflation. They fear that if they do nothing, then people will believe they are not serious about combating inflation. So, rather than do what is right, they could pull the interest rate trigger even if it will do nothing to fix the problem.

The warped logic is that it is better to be seen to be doing something, even if that makes things worse, than to admit they can’t fix the problem.

They will justify increasing interest rates by saying that they need to prevent inflationary expectations. If people think inflation is going to stay high, then they will demand higher wages to compensate for the higher prices. If they succeed in getting higher wages, this will increase businesses’ costs of production, and they could increase prices, adding to inflation.

There are a lot of ifs in that train of logic. The biggest is the idea that workers can just get higher wages if they want them. Workers have been struggling to get wage increases for more than a decade.

But the biggest problem is that there is no evidence that inflationary expectations have increased. The RBA is just assuming they have increased because inflation has gone up, even if that inflation is linked to an event overseas that could end at any time.

The RBA increased interest rates at their last meeting, but it was a split decision, with five wanting to increase and four wanting to keep them on hold.

Let’s hope that on this occasion, they don’t increase rates. Australia doesn’t need more economic pain.