Are there any (good) alternatives to interest rate hikes to cool inflation?

analysis Are there any (good) alternatives to interest rate hikes to cool inflation? It is an overused metaphor that monetary policy, the interest rate decisions of Australia's Reserve Bank board, is a "blunt tool" for managing inflationary pressures in our economy. So, it's only reasonable for mortgage holders, reeling from the blunt force trauma inflicted by five interest rate hikes this year, to ask two main questions: are there any other tools that would be better? Or if adjusting interest rates is the tool we must continue to use, will it work? But before we peek inside the alternative inflation-fighting tool chest, here's a quick recap of how the interest rate tool actually works. How do interest rate rises work to slow inflation? While the impact of rate hikes on those with big mortgages gets most attention, in fact, higher interest rates work in four main ways to cool price rises. Hurting borrowers is the last way. First, higher interest rates push up the value of the Australian dollar, which makes imports cheaper. A higher dollar also boosts the incentive for local shoppers to buy foreign goods relative to domestically produced goods or, say, to holiday abroad, slowing demand for domestic companies and making it harder for them to charge higher prices for their products. Second, higher interest rates discourage spending by increasing the relative attractiveness of saving your money — in a high interest earning savings account, for example — versus spending it (which only works if you have spare money after essentials, of course). It also tends to make it less attractive for businesses to borrow to invest, which tends to cool the economy. Third, because borrowers can't afford to borrow as much money, this puts downward pressure on the prices of assets like housing, which in turn makes the owners of these assets including mortgage holders, but also those who own their homes outright, feel less rich and less likely to spend. Finally, and most obviously, of course, higher interest rates directly sap the spending power of households with variable interest rate mortgages. Some of this impact is offset by the higher return paid out to deposit holders, who tend to be older and richer, but Australian households overall borrow more money than they hold on deposit, so the "net effect" is to withdraw cash out of household pockets. Overall, higher interest rates cool demand and activity across the economy, making buyers less willing and able to pay the higher prices that business might otherwise try to charge. The upside of interest rate hikes is that they can be decided and implemented quite quickly. The downside is they take time to kick in with full force, typically 12 to 18 months. Balancing an economy, a collection of millions of individuals and businesses making spending decisions every second of every day, is not a precise science. It's hard for the Reserve Bank to know if they've done enough. The risk is they do too much and risk tipping the economy into a job-destroying recession. So, what other tools might we have at our disposal to curb the runaway cost of living? How about cutting government spending? Fiscal policy, the collective tax and spending decisions of governments, can also impact demand, and therefore prices, in the economy. Spending cuts, in certain areas, can take demand out of the economy. So, too, can tax increases. What determines whether a government's budget settings are "stimulatory" (inflation promoting) to the economy or "contractionary" (inflation fighting) is whether the annual deficit is getting bigger (or a surplus smaller), as a percentage of the economy, from year to year. At present, over the federal budget's four-year outlook, annual deficits are running at a fairly consistent 1 per cent of gross domestic product (GDP) and as such, are not imparting a large stimulus to the economy. Unlike monetary policy, fiscal policy decisions also come with significant moral and ethical dimensions. Government must take into account what health and education services the community wants, what level of safety net is desirable for the unemployed, what public infrastructure will best serve the nation, how best to ensure our national security, and so forth. As such, the consensus among most senior economic policy makers today remains that responsibility for managing the economic cycle should be left to the independent Reserve Bank board, while fiscal policy should focus on longer term questions about how to raise taxes efficiently and spend revenue in ways the community finds agreeable. Which is not to say governments can't and haven't helped to boost the economy in the face of external shocks, such as the global financial crisis (GFC) and COVID pandemic. It's more that it's unclear how helpful politicians will ever be at strategically taking money out of voter's pockets to cool demand in a timely way. What about an independent fiscal body to raise and lower taxes? It's an idea mooted by some. Pick a tax, such as the Medicare levy or the GST, and appoint an independent board to increase it to manage inflationary pressures, or to cut it to stimulate the economy. The idea of using a temporary tax is not completely without precedent. Most of former prime minister Tony Abbott and his treasurer Joe Hockey's 2014 "slash and burn" budget was destined for the cutting room floor, but a "temporary budget repair levy" was collected for two years at a rate of 2 per cent from individuals earning more than $180,000. Still, it required legislation and it hasn't been attempted since. No independent fiscal policy-setting body exists anywhere in the world today, and one suspects the coercive power of government to raise taxes needs ultimately to be offset by the democratic power of citizens to oppose and reject it, from time to time. What about forcing people to put money into super? In addition to taxes, of course, all employees also have 12 per cent of their pay packet whisked away to a superannuation fund for their retirement. What if, instead of squeezing only borrowers, we squeezed the cash flow of all workers by adjusting up the super guarantee so the money would be temporarily diverted into nest eggs, not the banking system? One way we got inflation down in the 1980s was when the Hawke-Keating government made an accord with unions and business to trade-off wage rises for a boost to workers' super. Could we do it again, but instead have a continuous mechanism to increase or decrease contributions as a tool for managing demand in the economy? It's an elegant thought in theory, but would require more investigation, particularly into the impact on long-term returns of increasing and decreasing contributions in line with the economic cycle. What about boosting the economy's supply capacity instead? What if, instead of trying to reduce demand to cool price pressures, we instead focused on boosting supply to constrain price rises? Obviously, there's not much we can do about wars causing supply shortages of key consumer goods, like fuel. But total supply in the economy includes not just goods, but also workers, equipment and capital. The efficiency with which we combine all these ingredients together determines our economy's productive potential. Lifting the supply side of the economy by upskilling workers, building better infrastructure and reviewing settings so that large firms can't put up barriers to new competitors entering the market would all help boost supply and balance out price pressures. Unfortunately, some of those things come with large taxpayer price tags which, whatever long-term supply expanding impact they may have down the track, only add to demand in the short-term. LoadingSo, which tool is best? Heavily indebted borrowers hoping to find a sharper or fairer tool than interest rate rises to curb inflation may ultimately be disappointed. Interest rate hikes are a terribly crude way to control inflation in the economy — until, that is, you consider every other alternative available. It might not be the most equitable tool we could design to relieve all Australians from the excessive burden of rapid inflation. But it's the tool we've got. And the history of inflation targeting suggests in the long run, no matter how painful it ends up being for mortgage holders and, in part, precisely because of that pain, it does work. [Image text:] MAEOANA RESEI OFA RESERVE BANK OF AUSTRALIA