min read
· Posted on
February 21, 2024

Are interest rates the only way to tackle inflation? Part 1: WTF is Monetary Policy?

Let's break down how monetary policy works and what other options are out there to bring down inflation.

What's the key learning?

  • How interest rates impact inflation
  • How the RBA Monetary policy works
  • Why spending isn't decreasing as expected
  • Supply-side shocks to inflation

Over the last 12 months, we’ve seen the Reserve Bank of Australia (RBA) tackle inflation by lifting the cash rate 10 meetings in a row. Holy moly - the RBA isn’t messing around!

By doing this, the RBA is hoping to slow down the economy to slow inflation, which has grown bigger and faster than the number of Fred Again superfans. 

Here’s their theory, broken down, baby step by step:

  • If interest rates go up, then mortgage repayments become more expensive
  • If mortgage rates become more expensive, people will think twice about some of their purchases (helloooo $7.50 iced latte)
  • If people think twice about their purchases, then demand for products and services goes down

If demand for products and services goes down, prices should decrease. 

But ironically, since the RBA started lifting interest rates from 0.1% in April 2022 to XX in March 2023, inflation has actually grown from 3.7% to 7.8%. Huh?! Go figure…

Quick refresher: Inflation is when the price of goods and services rise over a specific period of time - more on how that works here. 

Okay so the RBA has been raising interest rates to tackle inflation, without much success so far. 

So what other alternatives are there and why aren’t we using them?

Well firstly, what’s the current system?

Inflation started rising globally in mid-2021 after many countries were providing tonnes of financial stimulus to keep their economy running during the pandemic.

In the current system, the RBA has been increasing interest rates since May 2022 with the hope of reducing demand to push down inflation. And this, my friends, is called monetary policy (thanks ECON101).

And these increases are projected to continue till at least November 2023. Yup, this is gonna last a while…

Monetary policy is the the main lever that the RBA can pull to hopefully lower inflation and stabalise the economy.

The RBA right now...

Okay, we’ve been doing this for 11 months, why isn’t this working?

Well, these interest rate rises mostly affect mortgage holders who are only about one-third of the Australian population. 

Aaand, according to some economists, such as AMP’s chief economist Shane Oliver, monetary policy isn’t exactly kicking goals at the moment. On the whole, spending isn’t going down as fast as expected. The main reasons?

  1. The remaining two-thirds of Aussies who aren’t mortgage holders are far less affected by monetary policy.
  2. Many households are still comfy with the savings buffer they built over COVID
  3. Labour market is hella tight - the country ain’t struggling too much to create jobs atm

And most importantly, monetary policy doesn’t address any supply-side impacts to inflation.

Wait…what’s that?

More than half of inflation currently is caused by shocks to the supply of goods and services.

There’s been supply chain problems during and post the pandemic and supply disruption from the Russia-Ukraine war. 

With lower supply of essential goods and services, we’re seeing sky-high prices.

And the  RBA’s monetary policy simply isn’t actually able to address these factors.

Are there alternatives?

In short, yes they are, but this article is getting pretty long so we’re going to explore them in part two and part three below:

  • Part two - Fiscal policy as an alternative to tackle inflation
  • Part three - Delayed spending as an alternative to tackle inflation

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