Fighting inflation with interest rates

Harold Levin

A large part of the current excess demand driving inflation is due to the banks and other financial institutions excessively expanding credit. Should the burden of fighting inflation so caused be primarily placed on households, renters, and governments undertaking essential public spending? There are serious social and economic consequences from relying on changes in Reserve Bank interest rates to combat inflation.

First, it inflicts severe stress on hundreds of thousand of households paying off mortgages. Those who can't meet repayments risk losing their homes. Yet these households are not the target. Their pain is collateral damage like innocent civilians injured in a military attack.

Second, many renters suffer great stress through a steep rise in rents. Higher interest rates reduce house buying and construction, forcing more households into competing for rental accommodation from a limited supply. These higher rents exacerbate inflation which could trigger a further rate rise. Renters' stress is also collateral damage.

Third, reliance on the Reserve's interest rate controls is stifling the Rudd government's policy program. To discourage the Reserve from further raising rates the government is cutting into existing programs and minimising increased expenditure, even in areas starved of funding under the Howard government such as public hospitals, universities, public schools, public housing and scientific research. This will considerably delay major improvements in these critical facilities and services. Moreover, the government's equivocal response to the interim Garnaut Report appears to indicate resistance to funding big picture policies to combat climate change because of the same interest rate fears.

Bizarrely, if these spending sacrifices over vital public services succeed in avoiding rate increases, it could encourage private sector borrowing for developments - for example shopping malls - of marginal community benefit. The government was not prepared to abandon the politically sensitive pre-election promised tax cuts or slash much of the previous government's middle-class welfare - non-means tested family benefits, the over $3.5 billion annual subsidy for private health care and the generous over-formula payments to rich private schools - as an alternative to increased funding for its priority areas.

Fourth, a rise in rates well above those in the major economies raises the $A which damages many of our export and import competing industries.

Finally, a rise in interest rates is a blunt and unpredictable instrument with a significant time lag. Several increases can provoke a recession before the Reserve Bank can play catch-up with rate cuts.

The current free market in finance lending hurts the financially weakest most and the financially most powerful least.

There is an alternative. Until bank deregulation in the mid-eighties, fighting inflation was not dependent on raising interest rates. The Reserve Bank determined the volume of increased lending the economy could accommodate without inflationary pressures. In times of excess demand, it could direct banks to lodge a proportion of their deposits with it (called the Statutory Reserve Deposits), require cuts in credit to particular sectors and, where desirable, regions of the economy while maintaining lending to other specified sectors of government priority - such as farmers, exporters and prospective home owners -and depressed regions. With today's increasing role of non-banking financial institutions, there is a strong case for bringing the largest of these within the Reserve Bank's purview.

The government could also combat inflation through the following complementary actions when it gets the interest rate elephant off its back, since they involve increased spending.

An increased public housing program for lower and middle income groups would reduce rents - and house prices - and therefore the CPI. Such a program would produce greater certainty of a substantial and more rapid increase in housing supply than the proposed tax incentives to the private sector. The macro effects of funding rental housing through cutting into the surplus or through government borrowing would be little different to funding through the private sector. In either case the competition for resources could be avoided by Reserve Bank credit cuts as outlined above.

A substantial increase in funding for public schools, especially to increase the employability of the scholastically weakest school leavers, and for the states' TAFE colleges would contribute to reducing the shortage of skilled labour while hundreds of thousands remain on unemployment benefits and many are working short hours because they haven't acquired the skills in need.

Expanding affordable, quality child-care would release scores of thousands of mothers into the work-force and, combined with the expansion of training programs, also help overcome labour shortages.

The above two progams would reduce dependence on the current level of immigration which, over the past decade, has been the largest since the post-war migrant boom. With the exception of a relatively small number of skilled migrants filling key vacancies, migrants add much more to demand than to supply and are therefore a major inflationary factor, especially through their impact on house prices and rents.

The government's fiscal approach to inflation - holding down public spending to discourage the Reserve Bank from raising interest rates - results in the exacerbation of some of our worst social problems and obstructs a long-term solution to inflation. Additionally, the current free market in finance lending hurts the financially weakest most - such as households paying off mortgages - and the financially most powerful least - such as those businesses which can pass on higher rates to customers.

Surely it is time to rethink the efficacy of present policy.


Harold Levien lives in Dover Heights, Sydney.