Senate Economics Legislation Committee, , 3:08:26 to 3:17:15
Discussion on how compounding supply shocks from climate change and global conflict impact inflation expectations and the effectiveness of monetary policy.
Topics: Climate change, Energy prices
Speakers: Michele Bullock, Senator Nick McKim, Andrew Hauser, Dr Christopher Kent, Unknown Speaker
All right, thanks morning, folks. Thanks for your time this morning. I just wanted to tease out some of the banks uh expectations around uh medium and longer term uh inflation expectations. Um obviously when you set your horizons that far out, you do enter the territory of Mr. House's nightmare scenario. Um, you know, recently we've seen impacts of COVID on the supply chain, the Ukraine, uh Trump's tariff shocks, Iran, um the bond yield leap, uh you know, got our climate system crumbling around us, we've got a record El Nino heading our way. Um these are obviously, or would you agree that these have a compounding impact on the bank's inflationary outlook in the medium to longer term? And if you do um agree with that, um what do you what do you think is going to happen to uh interest rates as these things continue to compound? And how's the bank going to respond to that and is monetary policy equipped to respond to that?
Um so um let me start and then um others can chip in. Um the first thing is you've highlighted a number of supply shocks that have occurred over starting with COVID and have continued. Now, what supply shocks do, um, negative supply shocks, is they raise uh they they basically worsen the trade-off between inflation and unemployment. So for any given unemployment rate or given state of the economy, inflation is higher. Um a traditional way of thinking about this is that, and and all central banks talk about this, is that you would try to look through the supply shock. So if it's a shock, you let it flow through, and then once it's flown through, prices will settle down again and inflation will settle down again. Um that works, I think, if you've got sort of a one-off shock, and you and you can do that. So if you just had a one, but if you've got, as you point out, compounding shocks, and they are continuing to raise the level of inflation, then there is a concern that people start to think that inflation is just going to be higher permanently.
That's right.
And if that is the case, then I think it's very difficult for central banks to, and and again, I'm sort of invoking some of my colleagues overseas. I think it's difficult to completely look through these uh these shocks because it might become embedded in inflation expectations. There's another challenge here too, which is um that something like a fuel price shock is a little bit more difficult because it underlies costs that are embedded in businesses. And um, if it's a very quick shock, goes up and it comes down again, businesses might think, well, I'll just wear it, right? But the longer it goes on, the more they might think, well, actually, you know what, the fuel price isn't coming down, transport costs aren't coming down, I've just got to start passing this on. That's right. So it does make it more challenging for central banks. Um, but the best tool for still remains the best tool for um making sure that inflation expectations remain contained and that the central bank remains credible in that is using the interest rate.
Uh so it's Christopher Kent here, assistant governor financial markets. I was just going to add the market measures and what they're doing. So the short-term market measures for inflation expectations for Australia had actually been picking up quite a bit through 2025, and then got another kick on with the uh war in the Middle East earlier this year, and they've since come back a bit at the big peak. Uh the that's consistent with what we've seen with inflation. Inflation is actual inflation's risen, and we've got these other pressures we've talked about. The longer-term measures have been quite stable right through this period, and that's not true just of us, that's true of other advanced economies. And one of the reasons is because markets anticipate central banks responding to these short-term inflationary pressures by raising interest rates. And indeed, the fact that the board has done so four times this year has probably been one of the very helpful things in containing those long-term inflation expectations.
All right, thanks. Um, I guess my proposition that I'd like you like you to respond to is I mean, are the first 10 rules of Mr. House's nightmare starting to seep into the minds of the board here because you know the lag on just to pick one of the things I mentioned, the lag on climate change is massive. Um the very system that actually supports human life, all other life on the planet, and for that matter, the global economy is collapsing around us. Um is it the board's view that you're just going to keep putting up interest rates and smashing people who are actually not responsible for creating the inflationary pressure? I mean, is monetary policy fit? Is money does monetary policy remain fit for purpose in the medium to long term in your view?
So I'm actually going to let me make a couple of points and then we'll let Andrew respond to, since everyone keeps talking about his comment. Um let's be clear here, uh Senator. At the moment, yes, we've had supply shocks, but there is a demand component to this for Australia. So we are not just responding to supply shocks. We are actually responding to a demand component. That's got to be that that has to be extremely clear here. Now, the second thing is that, as I said earlier, um we need to make sure that we keep demand and supply relatively well aligned, and monetary policy is fit for purpose in that. Now, will we have to have a better understanding of where we think supply shocks occur and we can look through them? Yes, we will, and we are working very hard on understanding that. We're working very hard on um adjusting uh adapting our models to try and get better at recognizing supply shocks and how to respond to them. But I think the bottom line remains that um there are going to be a lot of supply shocks, and but there are also going to be demand consequences of interest rates, and central banks still need to be involved in setting interest rates to try and make sure that inflation remains low and stable and at target. Uh Andrew, I don't know if you'd like to add something.
Yeah, um you've mostly covered it, Governor. Let me just say a couple of things, Senator, if I can. As Chris said a moment ago, you know, in some ways the surprising feature of the post-COVID period is how well anchored inflation expectations remain, not just in Australia but around the world. Obviously, inflation picked up very, very sharply, uh, and you might have expected for there to be some tendency for inflation expectations to pick up in response. And around the world it did not. Now, that was obviously because central banks responded quite aggressively, uh, and that obviously created uh pain and difficulties in their relevant economies. But as Chris said, that probably was what was required to keep expectations well anchored. Most of the measures of long-term expectations remain pretty well anchored. One thing that we are looking at, uh, and I think has has taken our interest, is what companies are beginning to think about the outlook for inflation given the cost pressures uh that they face. And both through our liaison and through a survey that we've been involved with who Macquarie University called the Boss Survey, there's just some sign that some companies might be thinking, do you know what? Maybe prices aren't going all the way back, uh, and if they're not, we're going to have to take that account into that in that into account in their pricing decisions. It isn't a claxon, it isn't my nightmare yet, but it is something we're watching quite closely. And obviously, consumer confidence measures are at historical lows, and people are very angry about the cumulative effect of inflation over the recent past that is not unique to Australia, that is true right away right around the world.