The RBA’s use of the cash rate to control inflation is flawed in premise, unfair to borrowers, and politically motivated. The RBA should therefore have no obligation or authority to set rates.
The standard approach assumes that high CPI reflects excess consumer spending. Raising the cash rate (and thus bank lending rates) is meant to increase borrowing costs, reduce disposable income and aggregate demand, and thereby lower prices.
This treats a symptom rather than the cause. Inflation can arise from external or policy-driven factors unrelated to domestic demand. Consider these cases, each of which can push CPI (inflation) above target:
- A Middle East disruption sharply raises global oil prices.
- A fall in mining revenues weakens the Australian dollar, raising the price of imports.
- Higher US yields driven by US fiscal deficits attract Australian capital offshore, weakening the dollar and raising import costs.
Each of these cases increases costs and prices across the economy. In none of these scenarios do borrowers enjoy extra spending power or businesses enjoy higher margins. They face higher purchase prices and then higher interest costs when the RBA raises rates to bring CPI back within the target range of 2 to 3% pa. This is an undeserved double hit from events beyond their control.
This begs the question of why interest rates are raised in these circumstances. It is done for political purposes. Higher CPI increases pressure government to maintain real incomes for public-sector workers and welfare recipients, enlarging deficits. By having the RBA tighten policy, government shifts the pain onto borrowers while distancing themselves from the consequences. The RBA, being unelected, absorbs the criticism.
A further case is more direct: A ballooning public sector, rising welfare costs, and public project mismanagement produce fiscal deficits that the RBA accommodates by expanding the money supply, by digitally printing more money. The resulting inflation prompts rate rises that again punish borrowers for a problem created by fiscal and monetary policy.
CPI movements often reflect global forces or domestic policy errors, not the health of the private economy. There is no justification for imposing higher interest costs on Australian borrowers in such cases. Interest rates should be removed from the RBA’s control and left to market forces.