Policy Impact

Low Inflation

As has been discussed previously, monetary policy is used primarily to regulate the rate of inflation in the Australian economy. Through the careful manipulation of interest rates and persuasion through the quarterly statements the RBA is able to control the level of aggregate demand in such a way that the rate of inflation can be predicted with some confidence.

The theoretical impact is apparent. When interest rates are increased the discretionary income of those with loans will fall (the cash flow channel), and some who were considering taking out loans will now choose not to (the credit and money channel). As a result, the level of consumption and investment in the Australian economy will fall, and therefore so will aggregate demand. This should reduce the upward pressure on prices that was previously occurring due to pressure on productive capacity, and as a result the rate of inflation will fall.

It is very important to note that although the graph above shows a fall in the general price level, in reality this is very unlikely. Deflation (a sustained decrease in the general price level) has not occurred in Australia since before World War 2. As such, any conclusion that suggests that increasing interest rates will lead to a fall in prices would be incorrect – the data does not back that up. However, we can say that there will be less upward pressure on prices – prices may well continue to increase, but they will probably not increase by as much. In other words, the rate of inflation should be lower.

As the pursuit of low inflation is such a major goal of the RBA, there are several excellent examples in the last ten years that show situations in which monetary policy was manipulated to affect the rate of inflation.

Underlying supply side pressures have been very difficult for the RBA to manage effectively, and as a result the inflation rate was consistently recorded at or above the top of the acceptable range during 2006 and 2007. With the election of the Labor government in November 2007, the new Treasurer Mr Wayne Swan announced that these pressures would remain in the economy until at least the end of 2009. It is for this reason that the RBA adopted a contractionary stance at this time; it was necessary to restrict increases in aggregate demand until the supply side of the economy was able to start expanding once again.

As we now know, the global financial crisis changed everything, and as the economy moved into 2009 the RBA was far more concerned with protecting jobs than reducing inflation. However, it is significant that by the end of 2009 the RBA acted to increase the cash rate in three consecutive months. This was repeated at the beginning of 2010. In taking this action Australia was the second economy in the developed world to increase interest rates after the crisis. In fact, there are many who would argue that this moment marked a turning point for the global economy. As the Australian economy recovered, this action was necessary to ensure that the strong stimulatory stance was not likely to cause inflation. When inflation was recorded at 2.9% after the March quarter of 2010, the board of the RBA knew that they had taken an appropriate approach. Any higher and it would have exceeded the goal range.

Current Page: Price Stability