Economist Alexandra Colalillo examines the question of whether a higher cash rate is the right policy response to a negative supply shock.
Supply chains affected during the COVID pandemic are now further disrupted by the Russia–Ukraine conflict, representing one of the greatest worldwide economic shocks since the global financial crisis (GFC).
This negative supply shock has been further exacerbated by various sanctions on Russian energy imports by several countries, including Canada, the UK and the US. The conflict has also seen some energy-producing companies making the decision to cease operations in Russia.
Reduced supplies of energy, metals and agricultural commodities, paired with a stronger-than-expected rebound in demand, has placed upward pressure on output prices for commodities and commodity derivatives (e.g. higher prices for crude and petroleum derivatives such as ethanol and polyester have increased prices of palm oil and cotton) in all countries, including Australia.
In developed and developing economies, rising commodity prices will ultimately weigh on growth, further complicating policy decisions facing central banks. It therefore makes sense to pose the question: is the tighter monetary approach (i.e. higher cash rate) adopted by Australia in an effort to reduce prices the right policy response?
Focusing on the energy market specifically, there are three key features that make addressing the current negative supply shock difficult relative to previous episodes.
First, there is less room to substitute away from most-affected energy commodities – gas and coal – as price increases are systemic across all fuels and, as a by-product, this has also increased production costs of other commodities.
Second, gross domestic product (GDP) stemming from energy consumption has fallen since the 1970s and consumers may therefore be less sensitive to relative price changes in the short term.
Finally, policy responses have prioritised energy subsidies and tax breaks, rather than focusing on the underlying imbalance between demand and supply.
Inflationary impacts on commodities
In response to supply disruptions, energy prices (in US dollar terms) experienced the largest 23-month increase since the 1973 oil-price hike. Specifically, there have been broad-based increases across all fuels.
In March 2022, Brent crude oil prices experienced a 55 percent increase in the time since December 2021, averaging $US116 per barrel, before easing in April following announcements of significant releases of oil from US strategic inventories and other International Energy Agency (IEA) members.
Natural gas prices in Europe also reached an all-time high in March 2022 due to fears of import disruptions from Russia. US natural gas prices rose by almost a third in March relative to December 2021, in part reflecting increased demand for US exports of liquefied natural gas.
Coal prices also reached an all-time high in March due to increased demand as a substitute for natural gas in electricity generation.
Most non-energy prices have also increased since the beginning of the calendar year, with a particular focus on fertilisers, nickel, wheat and oilseeds. Among agricultural commodities, wheat prices saw a very steep increase, almost 30 per cent higher in March compared to December 2021.
Due to production shortfalls in South America and disruptions to Ukraine’s sunflower seed oil exports, edible oil prices have spiked sharply in 2022. And due to the surge in natural gas and coal prices, fertiliser prices spiked in the first quarter of 2022, as both are key inputs into fertiliser production.
The S&P Metals & Mining Index, which includes constituent producers of gold, steel and precious metals, rose 13 per cent in the first quarter of 2022. Specifically, nickel prices rose 35 percent and iron ore and aluminium prices saw large increases due to Russian supply restrictions.
According to the World Bank, commodity prices are expected to remain high in the medium term and significantly higher in 2022 than in 2021. The price of Brent crude oil is projected to increase by 42% in 2022 from 2021, its highest level since 2013, averaging $US100 per barrel.
Similarly, non-energy prices are expected to increase by approximately 20 per cent in 2022, with the largest increases in commodities where Russia or Ukraine is a key exporter.
The duration of supply shocks, however, is heavily dependent on the continuance of the conflict in Ukraine, a longer-term conflict with the West, and the severity of disruptions to commodity flows.
Is Australia adopting the right approach?
Policy-makers have taken various actions to alleviate price volatility in response to inflationary pressures. We have a situation where customer demand across the global economy is exceeding the capacity of businesses to provide goods and services and, as a result, rising competition for these goods and services is placing upward pressure on prices.
In May, the Reserve Bank of Australia (RBA) increased the cash rate by 25 basis points to 0.35 per cent in an effort to address headline consumer price index (CPI). As of mid-July, the cash rate had been increased to 1.35 per cent.
Even core underlying inflation, which excludes extreme price movements, clocked in at 3.7 per cent for the trimmed mean and 3.2 per cent for the weighted mean – 0.5 percentage points higher than forecasted predictions.
Why did the RBA increase the cash rate?
The impact of the cash rate hike will ultimately dampen consumer demand and increase the cost of borrowing, designed to negate inflationary pressures. Further, the US Federal Reserve hiked rates again in May by half a percentage point to a range of 0.75–1 per cent. As of mid-July, this had risen to 1.50–1.75 per cent.
If Australia did not follow suit, global investors would shift towards countries with higher interest rates (e.g. the US), which would cut the value of the Australian dollar and push up the prices of imports, further increasing inflation.
However, is this the right monetary policy decision amid the current economic situation? Three key factors suggest otherwise.
First, what distinguishes the current situation from other economic shocks is the fact that inflation is not driven as much by domestic Australian demand as it is by global supply-chain disruptions due to the pandemic and the geopolitical conflict. Increasing the cash rate in an effort to dampen demand is therefore unlikely to have a material effect on global prices, particularly commodity prices.
This is particularly the case given negative supply shocks are likely to prevail in the medium term. According to the Treasury, Australia’s border closure has permanently reduced the size of the post-pandemic workforce, estimating population growth to 2030–31 will reduce by 1.5 million people.
In turn, annual growth is set to slow below two per cent over the next 20 years assuming the current pace of technological progress is maintained. Suppressing domestic demand may therefore not achieve the desired effect and only further decrease employment and economic growth.
Second, if economic and wage growth remains mild and unemployment begins to increase while inflation persists, there is a risk of future ‘stagflation’. Two major supply shocks in the 1970s (both involving oil) led to stagflation and contributed to the weakened post-World War II financial order.
However, modern economies are far less reliant on the direct use of oil than they used to be as we have become more efficient at using greener technology and economies have shifted from industry to services which use less energy. Rising oil prices should therefore be less of a drag on economic growth than in the past.
Despite this situation, there is still a risk that raising the cash rate will prematurely depress economic activity at an unfavourable time, and as negative supply shocks perpetuate, decisions about how much to tighten monetary policy and for how long will become more difficult over time.
Third, while Australia’s seasonally adjusted wage price index rose by 2.3 per cent in the final quarter of 2021, after a 2.2 per cent increase in the third quarter, it’s well behind inflationary figures and increasing at a slower rate due to public sector wage caps, the modest size of minimum wage and award increases, and enterprise agreements that lock in pay rises for several years.
If wages don’t follow suit with inflation, a rising cost of living would place downward pressure on demand regardless of whether tighter monetary measures are implemented.
In addition, to compensate for the effects of higher inflation on purchasing power, workers may then seek large wage increases. In turn, higher wage growth raises costs, leading firms to raise prices further and/or reduce the number of workers they employ.
In response to negative supply shocks, recent global policy responses have generally favoured trade restrictions, price controls and subsidies, which are likely to exacerbate shortages.
In Australia, the short-term priority should support households facing higher energy and food prices and reducing global supply chain reliance. In the longer term, the focus can pivot to energy efficiency improvements, the facilitation of new investment in net-zero sources, and the promotion of efficient food production.
This feature appeared in the June issue of Australian Resources & Investment.