I wasn’t planning on writing a note today, despite the speeches in recent days by central bank officials. Then I saw an Instagram post from a local bookstore café explaining that it would be raising prices because of higher rents, labour costs and other operating costs.
At first glance, it sounds like a small local story. In reality, it neatly captures the challenge facing the Reserve Bank of Australia (RBA) ahead of next week’s meeting.
The bookseller is facing the same dilemma confronting many businesses across the country. Costs have risen. Margins are under pressure. Businesses face a choice. They can absorb those higher costs or pass them on to customers. The bookstore cafe has chosen the latter.
That’s precisely where the RBA’s concern lies.
The RBA is worried about the indirect and second-round effects of rising costs. Put simply, second-round effects occur when an initial rise in costs, such as energy, fuel or freight, spreads through the economy and prompts businesses to lift their own prices. Industries such as transportation, construction, mining and agriculture are particularly exposed to higher fuel and input costs. Those higher costs can then be passed on to other businesses and, ultimately, consumers.
If domestic capacity pressures and elevated short-term inflation expectations persist, the likelihood of those higher costs being passed through to broader consumer prices increases, making inflation harder to return to target.
Governor Bullock devoted a significant amount of time yesterday to discussing geopolitics and the changing global environment. The message was clear. Inflation is not just a domestic-demand story.
The fragmentation of the global trading environment and the rise in geopolitical tensions mean price pressures are likely to be more persistent than they were in the past. There is not much the RBA can do to influence where those shocks originate.
Take the Middle East conflict. Higher oil prices are only part of the story. Diesel markets have also been affected by refinery outages and infrastructure disruptions. Higher diesel costs then flow through to freight, agriculture, mining and construction. Ultimately, they increase costs for businesses right across the economy, including local booksellers and cafés.
The world price of Brent crude has averaged 17.4% higher since the August RBA meeting than it did between the June and August meetings. A sustained increase of this magnitude risks eventually showing up in business costs and the prices paid by consumers.
For much of the past two decades, globalisation and open trade helped keep inflation contained. Supply chains became more efficient, trade expanded and businesses could source goods and inputs at lower cost. That backdrop is changing. Today’s environment is characterised by geopolitical tensions, greater trade fragmentation, energy security concerns, rising defence spending and large investment requirements in areas such as the energy transition and digital infrastructure. Countries are turning more inwards and chokepoints, like the Strait of Hormuz, are being weaponised.
Whether it is higher energy prices, freight costs or broader imported cost pressures, the RBA has little influence over where the shock originates. What it is trying to dampen are the second, third and fourth rounds.
Inflation becomes much harder to control when higher costs start showing up in the price of books, coffee, restaurant meals, haircuts, insurance premiums and countless other goods and services across the economy. One business raises prices. Then another. Then another. One bookseller raising prices will not move the inflation needle. But when thousands of businesses across the economy are making similar decisions, it becomes exactly the sort of thing central banks worry about.
The real risk for policymakers is that inflation expectations drift higher and become embedded. Businesses become quicker to raise prices because they expect costs to keep rising. Workers seek larger wage increases because they expect inflation to persist. Consumers become more accepting of price increases because they see them everywhere.
Once that process takes hold, inflation pressures can grow or become stickier.
Another theme that stood out from the Governor’s remarks yesterday was the labour market. Bullock again suggested that unemployment may need to rise to ensure inflation returns sustainably to the 2-3% target band. She suggested a band of 4.5% to 5% was needed. That is a significant observation because it speaks to the amount of slack the Bank believes may be required to fully extinguish inflation pressures. The Governor also continued to characterise the labour market as a little bit tight. Fresh labour force data is out tomorrow. We are expecting a rise of 20,000 jobs in August and the unemployment rate to stay unchanged at 4.5%, which is also in line with consensus forecasts.
A rate rise next week would not be aimed at lowering oil prices or resolving geopolitical tensions. Rather, it would help dampen demand, keep inflation expectations anchored and limit the second-round and indirect effects that can transform an external shock into persistent domestic inflation.
We continue to expect one further rate hike next week. We expect the unemployment rate to move towards the upper end of the 4.5-5.0% range by the end of this year, so our central case for now remains one more hike followed by an extended period on hold. A further increase in November cannot be ruled out. Financial markets are taking a more hawkish view with swap markets pricing the equivalent of 2.4 additional rate hikes by mid 2027.
