Transcript of Question & Answer Session A Narrow Path

Phil, aren’t you fighting an uphill battle here with the Australia government just spending money with their ears pinned back? If you want to spread the pain a little bit and get the adjustment coming through quicker to get supply and demand in line, surely on the fiscal side they could be doing more.

I addressed this at Senate Estimates last week, and my summary of the Budget was that it was broadly neutral in terms of the inflation outlook. In the short term, it was helping. The interventions in the energy markets, the price caps and the rebates that the governments are giving some households on their bills will bring inflation down by roughly three-quarters of a per cent next financial year, so that’s helping. But broadly, fiscal policy is neutral at the moment and monetary policy is restrictive.

Dr Lowe, there’s been an assertion in the last few days that giving a pay rise to the lowest paid will have very little effect on inflation. What kind of effect would we expect to see from giving a pay rise to the lowest paid?

It really depends upon how widespread the larger pay rises are. It’s perfectly understandable for the lowest paid workers in the country to be compensated for inflation; it’s tough and we know it’s tough, so that’s perfectly understandable. We will get ourselves into trouble though, if we accept the premise that all workers need to be compensated for inflation because, if you accept that premise when inflation is seven per cent and wage rises match that, what do you think inflation will be next year? It will be high again and then they’ll have to have higher wage increases again. We’re in a difficult position where the society, understandably, wants to protect the lowest paid workers but we’ve got to make sure that the higher inflation doesn’t translate into higher wage outcomes for everybody because, if that happens, and inflation persists, we’ll be in the world that I spoke about before that we’re really trying to avoid. It’s a really tricky balancing act that we’re trying to manage at the moment.

Hello. The Reserve Bank undertook modelling that showed around 15 per cent of mortgage borrowers faced negative cash flows at a cash rate of 3.75 per cent. We’re now at 4.1 per cent. How much further do you think interest rates can rise before we see a serious rise in mortgage arrears, forced sales and defaults?

Those calculations that you referred to were based on the assumption that people made no adjustments. If people can cutback spending or in some cases find additional hours of work, that would put them back into a positive cash flow position. That’s not to say that there’s not very significant stress out there in households at the moment. But as I showed in the chart here, arrears rates remain low. People are affording to pay their mortgages; even as they roll off from the fixed rate loans to variable rate loans, the arrears rates remain low. But the banks are telling us—and this is understandable—that people are having to cut back in spending, and I think that’s going to be the environment we’re operating in for a while yet. People will make their mortgage payments, but they’ll be cutting back spending in other areas.

In our session earlier, Philip, we had Dr Richard Clarida, whom I know you know from his time on the Federal Reserve and now at PIMCO; I think he’s coming out here shortly. In the latter part of his presentation/discussion this morning, they talked about—well, the question came from our own global economist, Seth Carpenter: have they thought about a range for inflation in the US? They’ve got a single point at the moment, which is circa two per cent; they’ve talked about it. To Australia, a target range of two to three per cent—given that inflation is clearly not transitory at the moment and it seems to be sort of stuck well above that range, has there been any thought given to that two to three per cent range as being sort of the appropriate range, given that backdrop?

That issue was examined in the recent review of the RBA conducted by an independent panel, and they concluded strongly that the two to three per cent target is the right target for Australia. We’ve long had a flexible inflation target, and I think that’s served the country well. Inflation moves up and down, but we really want people to be confident, when it’s away from that target range, it will come back. We’re not specific about it needing to come back to an exact number, but we want you to be confident—we want the community to be confident, that it will come back to an average two-point-something, and I think that’s the right framework for Australia.

Yes; and you’re being very clear in your messaging that it’s your resolve and the Board’s resolve to get inflation back into that range.

That’s our job—to do it—because, as I said in my prepared remarks, if inflation stays high, we’re going to feel a lot of pain. The whole community will hurt. Inflation is corrosive and it hurts people on low incomes the most. We’ve got to get inflation back down, and I know that is difficult in the short run. But what we talked about at our board meeting yesterday is, if we were to avoid this difficulty in the short run, we will have a lot of pain in the medium term, and that will end up being more costly for us all. I know it’s difficult, but we need to get inflation back down and we’re really committed to doing that, and yesterday’s decision demonstrates that.

Governor, I want to ask two questions, please. Why has it taken so long to realise that (inaudible) is ineffective against six to eight per cent inflation, when the evidence offshore from central banks that have been on the job fighting inflation far earlier is that much higher rates are needed and also that they’ve had better success? Secondly, with the quantitative easing that we’re doing in unconventional policy, do you feel that the harm caused by that in the inefficiencies in the market have really been worth it with the long-term effects and do you feel that the bank might be better off operating with a more conventional structure of, say, a one per cent floor in rates and maybe with the fiscal measures hand back to the government?

There are a lot of questions there. The first one is kind of: why are our interest rates lower than the rest of the world? I mean, there are a few considerations. The first is that we had been prepared to have a slightly slower glidepath back to the inflation target than some other countries because we really wanted to lock in, if we could, this ‘once in a generation’ improvement in the labour market. Our Inflation forecasts have inflation returning to the top of the target band in mid-’25. Other countries were getting there earlier, and we were comfortable with that. That was one factor. Another factor was that most Australians have variable rate mortgages. In the United States, when interest rates go up, if you’ve got an existing mortgage, you don’t pay any more. In Australia, you pay more kind of within a week or two. So we’ve had, in Australia, a very big hit to household disposable income from higher mortgage rates; that doesn’t happen in other countries. That’s one reason, we think, that interest rates perhaps don’t need to go up as much as they do elsewhere. And a third factor has been that nominal wage growth in Australia was lower than it was in most other countries. Measures of wages in the US and the UK have been running at close to five; they’re lower here. They’re the three factors that have led us to have lower interest rates than the rest of the world, and if any of those factors change then we would have to reconsider. You asked about the use of quantitative easing or perhaps quantitative tightening. Now, it’s clear in retrospect that the central banks and the fiscal authorities did too much during the pandemic; I think that’s pretty clear. But when you think about that, I just invite you to go back to those days of the pandemic; it was scary. We did what we thought was the right thing at the right time with the information that we had. We wanted to do everything that we could to protect the country from the economic effects of the pandemic. We did that and, at a time we were doing that, we thought a vaccine would take years to be developed and the restrictions would last for ages, and it turned out the scientists developed vaccines in record time, we all got vaccinated and life returned to normal more quickly than any of us—well, at least certainly I expected, and that was the advice that we were getting as well: it would take ages. We did what we thought was necessary; in retrospect, we did too much. Now, with interest rates away from the lower band, our view is that interest rates remain the tool for monetary policy. And quantitative tightening isn’t really an effective monetary policy tool, when you can use interest rates, so the focus for us is very much on the cash rate.

Dr Lowe, just picking up on that last question from Neil, when we look at what’s been happening with this ‘hike group’, we had the pass in April and then we’ve had a May and June increase. You sort of relayed the message in April that you wanted to slow down the pace of rate hikes, and that was sort of well accepted by the market, and now we’ve gone back to an accelerated path of rate hikes. Putting together what you’ve been telling us today, and in the releases, is that because you’ve become more concerned about the wage measures? You’ve put a lot of emphasis on labour costs running at seven per cent, which has now gone into service inflation, so it looks a lot more like the rest of the world. So are we starting to look at least concerned about looking like the rest of the world? And is it also the case that the Board is less tolerant of any slippage on getting back to three per cent? So three per cent by mid-’25 is the forecast. Is the Board now less tolerant of taking that risk of taking so long compared to what’s happening in the rest of the world?

There hasn’t been any shift in our tolerance. We want to get inflation back to target within a couple of years, and that hasn’t changed. What has changed over the past couple of months is our assessment of the risks. And it’s not just the wages data. The inflation read for April was higher than expected; we’ve seen housing prices rising again, when we thought they’d still be falling; and, when we look overseas, we see a lot of persistence in services price inflation, largely again because unit labour costs are rising quickly; and there’s been a lot of strong correlation between inflation developments abroad and what happens in Australia. So upside surprises on inflation, upside surprises on wages, upside surprises on housing prices and upside surprises on inflation overseas. We felt like we couldn’t just sit idly and say, ‘Well this is just all accidental, it’s all just noise.’ The conclusion we reached was that this represents upside risk to the inflation outlook in Australia. We have been prepared to be patient in getting inflation back to target, but our patience has a limit, and the risks are starting to test that limit. So we thought we needed to respond after holding steady in April.

Good morning, Dr Lowe. Every month, when you make your decision on rates, everyone is very keen to express their view about what you’ve been doing, and I note your comment about the budget and existing policy. But I’m wondering, given it’s the only lever you can pull, what’s your view about what levers government could be pulling in addition to what they’re already doing to help bring down inflation? I’m talking about new policy, additional things they could do to help you.

The government doesn’t advise me on interest rates, so I don’t like advising them on whether they should do anything. That’s a good division of responsibility. But there’s a couple of additional observations I’d make. One is about the productivity reform agenda. We really need to focus on that because, if we’re going to have nominal wage growth of 3½ to four per cent, we need to have productivity growth of one per cent a year; we’re not generating that at the moment. That’s not fully within the hands of government, because business has an important role to play as well. That’s one area to focus on. The related area is the sustainable rate of growth in nominal wages, which we want to deliver 2½ per cent inflation for you over time, and hopefully the country can deliver some productivity growth. The sustainable rate of growth for nominal wages is equal to 2½ per cent plus whatever productivity growth we can deliver. So we have to face into that reality as a country, and faster growth in nominal wages can only be supported by faster growth in productivity.

Dr Lowe, Jim Chalmers certainly sounded like he was making some comments yesterday in relation to your decision. How do you respond to what he said in Canberra yesterday?

I’m not going to respond to particular comments he makes. He, like me, wants to get on top of inflation, so we have to do that, and the Board of the Reserve Bank is strongly committed to it. I think we can still do it with preserving the gains in the labour market or at least some of them. But if inflation stays high for too long, then we won’t be able to. That’s the path we’re trying to navigate, and the government understands that.

Yes. I don’t think any of us got a shock, once we saw the fair wage commission come out with a 5.75 per cent wage increase late last week, that we got an interest rate increase yesterday, and I’m sure there were many other factors that were taken into it.

Yes, there were many other factors. That was just one factor, as I said. And I think it’s important, because it’s not like we’re just responding to the Fair Work Commission. We’ve seen developments overseas, the domestic inflation data, housing prices, the exchange rate, the Fair Work Commission decision, state government wages policies and the federal government wages policy. There’s a whole bunch of things and, when a whole bunch of things all point to the same direction, it suggests the risks have shifted and, in our risk management framework, we respond to that; that’s our frame of reference.

Yes. And we’ve, again, heard Richard Clarida referencing back to the inflation in the ‘70s and the damage that did. That’s why all central banks are focused on slaying this inflation dragon, so to speak.

Governor Lowe, you have mentioned the Fair Work Commission’s ruling last week. Were you surprised by the increase in the minimum wage and how large it was? And how much is this going to add to the risk of a wage/price spiral in Australia over the next few months?

It was higher than we had factored into our forecasts, as I said in my prepared remarks. How much it adds to the inflation outcomes really depends upon whether it spreads across other parts of the labour market. The share of the labour force that’s covered by the award increases is still fairly small. The concern would arise if the 5¾ per cent increase became a benchmark or a quasi-benchmark for outcomes in private sector wages more broadly; I’m really hopeful that doesn’t happen. And the big increase last year didn’t become a benchmark for other increases. We have some experience here. But the longer these big increases go on, the harder it will be for wage outcomes in negotiated agreements to stay where they are. It’s a risk factor we’re monitoring and, as I said before, the solution here is stronger productivity growth to underpin big increases in nominal wages.

Dr Lowe, I’m just curious as to—a lot of things are going wrong; I’m just curious as to what you might think are things that could go right. When Dr Clarida was speaking before, he referenced the fall in American productivity down three per cent, a figure that he seemed to indicate he just did not believe. I’m just curious as to whether or not the productivity numbers that you’ve referenced in your talk today could be understating Australian productivity and we may see a rapid increase in productivity and the effect that that would have on the inflation and interest rate outlook.

We might be. Can I just take issue with your first comment: a lot of things are going wrong? A lot of things are going right in this country. We’ve got the lowest unemployment rate in 50 years; the highest share of people who are lucky enough to live in Australia have a job than ever before; the youth unemployment is the lowest in decades; commodity prices are very high; our terms of trade are basically the highest in 150 years; and our public finances, while we’ve got kind of medium-term issues, right at the moment are in pretty good shape. That’s a pretty good collection of facts and I think we can kind of forget that. So the country has got a very good base to work from, and the current rate of aggregate wage growth is consistent with inflationary returning to target, provided that productivity growth picks up. A lot of countries in the world would like that set of characteristics, and we’re there and I think we can still navigate our way back to two to three per cent inflation while keeping the gains in the labour market. A lot of things actually are going right. I know it’s tough for people at the moment, and that’s the inevitable result of the pandemic and Russia’s terrible invasion of Ukraine, and those two things have an effect on us all. But there is a path back to better times and increasing real wages. And, on productivity growth, I’m hopeful that it again picks up. And I think the pandemic really had a disruptive effect on businesses. I know, even at the Reserve Bank, how we had to slow down investment. It was disruptive and we couldn’t hire people, and it kind of affected us, and every business is the same. So I’m hopeful. But we shouldn’t fall into a state of despair. Australia has got a great economy. We’ve got great people and fantastic prospects. People want to come here; they want to come and live and work here and prosper here. We’re lucky, and I think we’ve got to remember that.

Yes. I think that’s a very good point, Philip, because what we are coming from is a set of interest rates that, not just in Australia but globally, were set for a pandemic that many—in fact, most—had never experienced in their life across the globe. We’ve gone from emergency settings at 0.1, and the normalisation is going to cause pain and disruption right around the world. So, it is the theme of this summit—‘disruption’—and I think the interest rate cycle is no different to that. I’m one of the older ones in this room who can remember when we had 17 per cent mortgages back in the early-to mid-’80s, so normalising to an interest rate of four per cent doesn’t cause me a great deal of concern; from a long-term perspective, these are still very relatively low interest rates. So I think your optimism is—

Yes. But, I mean, I want to kind of also acknowledge that the higher inflation: it’s hurting people, isn’t it? I mean, if the price level goes up seven per cent in a year, that really hurts people; when mortgage rates go up a lot, that’s hurting people. And I’m hopeful this will be how it plays out: inflation comes down and we can go back to rising real wages again and we can get through this period of difficulty. But the fundamentals that we have in this country are still pretty positive, very positive.

Yes. I think what we’re all seeking, ultimately, is: let’s get to that peak rate. From the peak rate, then we can start making, I think, very sound investment decisions.

Thanks. You’ve talked a lot today about if inflation remains for a period of time or is becoming embedded in expectations and you’re on a narrow path. are One of the risks that you guys consider being that the interest rate tool that you have won’t be effective across the board, given that the wealth in boom—that the demand is coming from a lot of people that interest rate increases don’t necessarily affect. Given that you’re across all the data, do interest rates hit enough of the population to be able to stifle the demand to get the results that you want in inflation? I guess, secondly, just linked to that is: given the increases in productivity that you’ve said are required, what period of time would the RBA look—because that’s not like mayday ‘productivity went up, so we’re okay’. Sort of for how long a period of time do you need that sustained?

I’ll take the first issue first. It’s clear that the higher interest rates are causing consumption growth to slow; we can see that in retail spending. And the national accounts come out in an hour, so we’ll see evidence of that, I assume, as well. But you’ve got to be careful not to think that the whole effect of monetary policy works through the mortgage channel. Remember what I said earlier that in the United States, when the Fed raises rates, people with an existing mortgage don’t pay any more. Yet monetary policy in the end works pretty much the same in the United States as it does in Australia. There are a lot of other channels through which it works: through the exchange rate, through affecting expectations, through expectations with the availability of credit and the investment outlook. So, in Australia, understandably, the focus of everyone’s discussion is the mortgage channel. But there are a lot of other channels that are working out there and affecting both economic activity and inflation as well., I think the monetary policy response is working, and the effect is most acute for people who have mortgages, isn’t it, and that’s really tough at the moment. We’ve got a more concentrated effect than in other countries. But the aggregate effect is working, as it is elsewhere around the world.

The service price is also around that issue, related to the housing (inaudible). You know, it’s across the (inaudible).

No. The strong growth in services prices, I think, is linked to strong growth in unit labour costs, and we’re seeing this in every advanced economy. Strong growth in nominal wages and weak productivity growth: that has to manifest itself in large price increases, and we’re no different from other countries around the world there.