RBA’s Inflation Struggle: The ‘Feet in the Oven, Head in the Freezer’ Problem
If your feet are in an oven and your head is in the freezer, on average you probably feel quite comfortable.
That’s the problem with averages. And it is a problem worth remembering when it comes to the task ahead of the RBA as they try to bring inflation down.
The RBA targets the Consumer Price Index (CPI). The CPI gives an indication of general price changes by measuring price changes across a wide range of things that consumers buy. These changes are then weighted according to how much of each thing a household buys. The result is known as a ‘weighted average.’ The CPI, then, measures average price rises.
This means that by targeting the CPI the RBA faces the ‘feet in the oven, head in the freezer’ problem. Specifically, the RBA has a contractual arrangement with the Treasurer to try to bring the CPI down within a range of 2-3%. The problem lies in the fact that, to achieve this target, the RBA just needs to get average price rises down to 2-3%. It does not need to keep all price rises below this level. Price rises in many of the things that people buy are unaffected by anything that the RBA does. That means that these prices will rise or fall according to things other than interest rate changes. If these ‘non-negotiables’ rise by more than 3%, then the RBA has to make sure that these rises are offset by smaller rises – or even falls – in the other prices, which are used to compile the CPI.
If you are measuring rises in the price of 10 things that have even weight in the index, and half of them rise by 4%, then the other half can rise by no more than 2% each if you want overall rises to stay below 3%. If half of the things you measure rise by 6%, then the other half cannot rise at all if you want the overall average rise to remain below 3%. And if half of the things you measure rise by more than 6%, then the price of the other things needs to fall in order for the overall average to remain at or below 3%.
Now, think about Australia’s experience over the last four years. We have literally had fires, floods and a plague. The global economy is also being buffeted by the financial implications of a war involving a major oil producer. All of these things have inevitably led to shortages of things that people need to buy, like petrol, food and accommodation. And those shortages drive prices up in these areas.
People can’t really cut back on purchases like petrol, food and accommodation. So, if prices in these areas continue to rise, then the RBA has to make sure that we spend a lot less on other things that are often described as ‘discretionary.’ Now think about the fact that, in the 12 months to March 2023, median capital city rents rose by 22%. And rent accounts for about 6% of the total CPI, so it is quite significant. As we show above, to offset something that increases by so much, the average price of everything else has to fall if the average increase is to be less than 3%.
The only tool that the RBA has to address inflation is the rate of interest. The general idea of interest rates is that if they rise, fewer people will take on new loans. This slows down the rate at which money moves through the economy, leaving people with less money to spend on discretionary items. Of course, higher interest rates affect existing loans as well, but in this case, the higher rates do not slow down spending as much because the higher expense that borrowers experience is offset by the higher income that lenders experience. Remember, anyone with savings is a lender. So, higher interest rates on existing loans move money from borrowers to lenders. But the money is still available to be spent – albeit by a different person.
This makes the RBA’s task all the more difficult. There are a lot of prices that they cannot influence at all. In addition, their main tool is very limited in the influence that it can have on the CPI anyway. Which might explain why, even after 12 rate rises, inflation is not coming down very quickly.
