How much higher do rates need to cut to kill inflation?

Australia’s economy has been rocked by inflationary pressures in recent years, prompting the Reserve Bank of Australia (RBA) to implement a series of interest rate hikes.

The latest interest rate hike, the 12th since April 2022, has raised the official cash rate target by 25 basis points from 3.85% to 4.10%. This move is aimed at curbing the stubbornly high rate of inflation and bringing it back within the RBA’s target range.

Former RBA Governor, Philip Lowe, has stated that the cost of living in Australia remains high, and it will take some time for inflation to return to the target range.

Meanwhile, the Fair Work Commission (FWC) has announced an increase in the National Minimum Wage to $882.80 per week or $23.23 per hour. This is an increase of 5.75%, just below the rate of inflation, which currently stands at 7%.

The relationship between the FWC’s decision to increase the minimum wage and its potential impact on inflation control measures implemented by the RBA has raised concerns in the market.

Some argue that the two entities are at odds. While the minimum wage is an essential policy tool to address income inequality and ensure fair compensation for low-wage workers, its influence on the broader economy, especially its relationship to inflation control measures such as interest rate adjustments, is a topic of ongoing debate.

It is true that an increase in the minimum wage can lead to higher consumer purchasing power and increased aggregate demand, which may fuel inflationary pressures.

This could increase labour costs for businesses, resulting in higher production costs and ultimately higher prices for goods and services, potentially exacerbating inflationary pressures.

This can trigger a wage-price spiral, where Australian workers demand further wage increases to maintain their purchasing power, leading to a cycle of rising prices and wages.

The RBA typically utilises interest rate adjustments as a primary tool to control inflation.

However, increasing the minimum wage may complicate the effectiveness of these measures due to the potential impacts on inflation expectations and wage dynamics.

If expectations of future inflation rise, interest rate measures may need to be adjusted more aggressively to maintain price stability.

However, if minimum wage hikes alter wage-price dynamics disproportionately to productivity, inflationary pressures may persist, requiring even more robust interest rate measures.

Some studies suggest that minimum wage hikes can lead to short-term increases in inflation, but these effects are often transitory and dissipate over time as other economic forces come into play.

Therefore, the long-term impact on interest rate measures to curb inflation appears to be limited. Other factors such as productivity growth, fiscal policies, and global economic conditions have more significant influences on Australia’s inflation dynamics.

The federal government who advocated for a pay increase for Australia’s lowest-paid workers should consider the broader macroeconomic context when evaluating the impact of minimum wage increases on inflation and interest rate measures.

Historically, there have been instances where increasing minimum wages have coincided with periods of inflation. However, while the minimum wage hike may have both direct and indirect effects on inflation dynamics, the long-term impact on interest rate measures to curb inflation some see as limited, whilst others warn it could tip Australia into recession.

Whatever the opinion it is clear that policymakers must adopt a comprehensive approach that considers the multifaceted drivers of inflation whilst protecting Australia’s most economically vulnerable, when formulating policies related to minimum wage adjustments.