Interest rates will need to rise further in Australia as the Reserve Bank will need to wring ‘embedded’ inflation out of the system, a leading economist has said.

Speaking at the recent Outlook breakfast hosted by Housing Industry Association in Melbourne, Westpac Chief Economist Bill Evans says that the Reserve Bank needs to act decisively to bring inflation under control even if this means drastically slowing the economy (see below).

During his presentation, Evans forecast that the RBA would lift interest rates by a further 0.50 percent at its October meeting on Tuesday.

Beyond that, the official cash rate will rise by a further 0.25 percent in each of November and December and February.

Put together, this will see the official interest rates rise from the current rate of 2.35 percent to peak at 3.6 percent in February.

According to Evans, the current inflation cycle can be viewed in three stages.

First, there were the global supply chain constraints associated with the pandemic. This saw prices for items such as shipping soar amid a huge shift toward online orders.

Next, the Ukraine war delivered a shock not only to energy prices but also to prices for wheat and base metals of which Ukraine and Russia are big producers.

To a large extent, much of the impact from these shocks has now eased. Prices for both wheat and base metals now sit at levels seen before the war.

Turning to construction, Evans says material price inflation has eased notwithstanding that prices for some energy-intensive materials such as concrete may rise as the full effect of higher energy costs flow through.

In the US, lumber prices have collapsed and prices for steel bar are declining as the construction sector in that country has collapsed under the weight of high interest rates.

Whilst this is yet to happen in Australia, Evans says we are now moving toward an oversupply of timber and that inflationary pressures from timber and steel are beginning to ease.

The problem, Evans says, is that inflation has now become embedded into the system and into the expectations of business and consumers.

Where this happens, he says central banks have few options for bringing inflation under control other than to hit the economy hard and weaken demand.

He says the size of this challenge should not be underestimated. Pointing to data from NAB and Westpac Economics, he says businesses on average across the economy have seen a 17.1 percent increase in year-on-year costs but have ‘fought back’ and have increased their prices by an average of 8.2 percent.

“The problem for central banks is the fear that inflation starts to get embedded into the system,” Evans said.

“When inflation gets embedded into the system, people get used to prices rising. Business that initially have to raise their prices to restore their margins start to see that people are accepting of higher prices. Therefore, they will continue to raise prices because they are profit maximisers.

“And people in the economy who have been so resistant to inflation for so long now start to believe that yes, ‘we have to accept the fact that this price is going up by 10 percent, what happened to discounting is no longer there’. If we look at the supermarket picture, that’s pretty clear.

“That’s the problem that people have. If we now look at say trade union expectations, they have gone from 1.5  percent to up to 5 percent. Consumer price inflation expectations are up to 6 percent. So people are now accepting of higher prices.

“What the central bank has to do is to wring that third stage out of the system.

“So the concept of higher prices starts with those first two stages – the oil shock and the supply chain shock – and then gets into the psychology of the system. Businesses have to restore their margins. Then they realise that people are accepting of higher prices and so can go even further. Consumers accept higher prices as well because ‘inflation is high isn’t it’.

“We saw that in the 1970s …. I remember what was happening in the 70s and 80s. That is what was happening. People were accepting of higher prices. That led to the lost decade of the 1970s. It led to extraordinarily high interest rates. Australia really only wrung that out of the system in the late 80s and early 90s when we ended up with 11 percent unemployment.

“We don’t want to go back there. That’s why central banks around the world are committed to wringing this third stage of inflation out of the system.

“How do you do that? Well, you send a very clear message to business that demand is falling off pretty quickly and that if you continue to try and raise your prices, you will find that you will lose market share very quickly.

“So that is why you have to flatten demand in the economy in order to short-circuit this third stage of inflation.

“That is what was happening in the 70s and 80s. If you look at history in business. Businesses have had no success in increasing their prices since the 1980s. But they are now feeling that ‘Ok, the trigger was higher costs. We are getting away with that, we are raising our prices. We are feeling that we are getting away with more of this.’

“The only way you can stop that happening is to make demand really weak so that businesses feel that they can’t keep doing that.

That’s what is behind these higher interest rates.”

(Expectations of inflation may lead to higher inflation becoming embedded into Australia’s economic system.)

Not surprisingly, Evans says the rise in interest rates will slow the economy.

Indeed, he expects that economic growth will slow from 3.4 percent in 2022 to just 1.0 percent in 2023 and 2.0 percent in 2024.

Unemployment (currently 3.5 percent) will rise from ultra-low levels of 3.0 percent at the end of 2022 to 4.2 percent by the end of 2023 and 5.0 percent by the end of 2024.

Whilst such a slowdown may not be desirable, Evans says it is necessary as bringing inflation under control now will avoid the need for more drastic action should high inflation persist over the next twelve months.

Aside from inflation, Evans says another economic challenge involves a shortage of workers.

Whilst the current unemployment rate (3.5 percent) is low by historic standards, Evans says this may understate the true extent of labour shortages.

Indeed, the true extent of shortage may be shown by seasonally adjusted job vacancy numbers, which sat at an estimated 470,900 in August despite being below 200,000 for most of the past forty years.

The effect is flowing through to wages. Whilst official data from the ABS shows only modest wage growth, a recent business survey from the National Australia Bank indicates that wage costs have risen by 11 percent over the past twelve months.

Along with strong demand, much of the shortage is being driven by the loss of immigration.

Prior to COVID, Evans says Australia would typically have positive net migration of 250,000. Whilst some of these were children, family members and older people, many are workers who contribute to the workforce.

During 2020/21 and 2021/22, by contrast, the nation experienced a net migration loss of 70,000 and 50,000 people respectively as COVID restrictions meant that leaving Australia was easier than gaining entry.

As a result, Australia lost around 120,000 people over a two-year period during which we would normally expect to have gained around 500,000. This means that the pandemic has thus far delivered an overall migration loss of around 600,000 – a number which is expected to increase as the government expects net positive migration of only 180,000 this year.

All this, creates challenges in returning to pre-pandemic levels of migration as well as dealing with the shortfall in migration of 600,000 people arising out of the pandemic.

In absence of migration, Evans says Australia will need to look at other ways to address the labour shortage. This could be done through means such as incentives to encourage more older Australians to work.

With record low vacancy rates, meanwhile, Australia will need to boost housing supply if we are to accommodate greater numbers of migrants – something which will not be easy with the housing construction pipeline expected to shrink albeit from record highs over coming years.

(Housing construction starts are expected to continue to contract from record highs)

From the viewpoint of the building industry, concern has been growing about the impact of rising interest rates on both house prices and demand for new construction.

In terms of the latter issue, Housing Industry Association expects that the number of starts in detached housing will continue to fall from record highs over the next two years (see chart).

HIA has become increasingly concerned over recent months that the Reserve Bank may overshoot on interest rate increases and that this may cause a greater contraction in housing demand compared with what is necessary.

On house prices, Evans says these will fall by 6.0 percent in 2022 followed by a further fall of 8.0 percent next year. This will be caused not so much by foreclosures but instead by a slowdown in new lending as interest rates rise.

On foreclosures, Evans says the number of these will be limited notwithstanding higher interest rates on account of the low rate of unemployment and the relative employment security of many borrowers.

Evan’s speech was given at the Construction Outlook breakfast hosted  by HIA in conjunction with major parters Colorbond, ARC ( The Australian Reinforcing company) and supporting partners Companion Systems and American express.

During the Melbourne event, HIA released a report showing Australia’s largest home building companies by volume of dwelling starts.

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