Speech
A Narrow Path
Philip Lowe[*]
Governor
Address at the Morgan Stanley 5th Australia Summit
Sydney - 7 June 2023
Thank you very much for the invitation to join Morgan Stanley's Australian Summit. It is a pleasure to be able to
join you.
This morning, I would like to discuss the narrow path the Reserve Bank Board is seeking to navigate.
That path is one where inflation returns to target within a reasonable timeframe, while the economy continues to
grow and we hold on to as many of the gains in the labour market as we can. It is still possible to navigate this
path and our ambition is to do so. But it is a narrow path and likely to be a bumpy one, with risks on both sides.
Today, I would like to talk about the importance of the destination - that is, a sustainable return of inflation to
target - and our strategy for getting there, including the decision yesterday to increase the cash rate again. I will
then turn to some of the factors that the Board is considering as it navigates the path back to 2-3 per cent
inflation.
The return of inflation to target
Recent inflation readings have been the highest for more than 30 years (Graph 1). The reasons for this are well
known. They include supply-side disruptions caused by the pandemic, Russia's invasion of Ukraine, and the large
fiscal and monetary policy responses that supported economies during the pandemic.
Graph 1
Consumer Price Inflation*
Year-ended
% %
15 15
10 10
5 5
0 0
-5 -5
1967 1981 1995 2009 2023
*
Excludes interest charges prior to the September quarter of 1998;
adjusted for the tax changes of 1999-2000.
Sources: ABS; RBA.
Our job at the central bank is to make sure that this period of high inflation is only temporary. It is important that
we are successful here.
High inflation is corrosive and damages our economy. It erodes the value of money and savings, puts pressure on
household budgets, makes it harder for businesses to plan and distorts investment. It makes us all poorer and
hurts people on low incomes the most. And if inflation stays high for too long, it will become ingrained in
people's expectations and high inflation will then be self-perpetuating. As the historical experiences shows, the
inevitable result of this would be even higher interest rates and, at some point, a larger increase in
unemployment to get rid of the ingrained inflation. The Board's priority is to do what it can to avoid this.
Over recent times the Australian economy has been operating at a very high level of capacity utilisation. This is
evident in survey measures of capacity utilisation (Graph 2). It is also evident in the labour market, which has
been very tight, with the unemployment rate having been at its lowest level in nearly 50 years. It is clear that total
demand in the economy has been pushing up against supply, and that, recently, this has been contributing to
the upward pressure on prices.
Graph 2
Spare Capacity
% %
Capacity utilisation*
85 85
80 80
75 75
% %
Unemployment rate
9 9
6 6
3 3
1993 1999 2005 2011 2017 2023
*
Non-mining capacity utilisation; investment share weighted.
Sources: ABS; NAB; RBA.
The return of inflation to target requires a more sustainable balance between aggregate demand and supply. The
tool that the RBA has to achieve this balance is interest rates.
I acknowledge that the use of this tool comes with complications. Its effects are felt unevenly across the
community, with rising interest rises causing significant financial pressure for some households. But this
unevenness is not a reason to avoid using the tool that we have.
It is certainly true that if the Board had not lifted interest rates as it has done, some households would have
avoided, for a short period, the financial pressures that come with higher mortgage rates. But this short-term gain
would have been at a much higher medium-term cost. If we had not tightened monetary policy, the cost of
living would be higher for longer. This would hurt all Australians and the functioning of our economy and would
ultimately require even higher interest rates to bring inflation back down. So, as difficult as it is, the rise in interest
rates is necessary to bring inflation back to target in a reasonable timeframe.
The evidence indicates that the higher interest rates are working and that inflation is coming down. The March
quarter CPI confirmed that inflation peaked late last year at 7.8 per cent (Graph 3). Subsequent to this, the
monthly CPI indicator showed a pick-up in the 12-month-ended inflation rate in April to 6.8 per cent. This was a
higher outcome than expected, but it has not changed our assessment that inflation is trending lower. Excluding
the volatile items and travel from the monthly CPI, inflation was 51⁄2 per cent in six-month-annualised terms to
April, compared with 71⁄2 per cent to October 2022 (Graph 4).
Graph 3
CPI Inflation
Year-ended
% %
8 8
Monthly indicator
6 6
4 4
Quarterly
2 2
0 0
-2 -2
2015 2017 2019 2021 2023
Source: ABS.
Graph 4
Monthly CPI Indicator*
Six-month annualised, excluding volatiles and holiday travel
% %
6 6
4 4
2 2
0 0
-2 -2
2018 2019 2020 2021 2022 2023
*
Seasonally adjusted; volatiles are fruit, vegetables and automotive fuel.
Sources: ABS; RBA.
There is also evidence of declining inflation pressures in global markets (Graph 5). Oil prices have reversed much
of the increase following Russia's invasion of Ukraine, as have the prices of many base metals. And wholesale food
prices, including for wheat and beef, have declined considerably. Similarly, the price of international shipping has
normalised after the surge during the pandemic. In time, these developments should be reflected in the prices
paid by Australian households.
Graph 5
Commodity Prices
US$/b index
Oil Shipping*
120 800
90 600
60 400
Brent crude oil
30 200
Container
index index
Wheat* Beef*
250 250
200 200
150 150
100 100
50 50
2019 2021 2023 2019 2021 2023
*
January 2019 = 100; indices produced using the US dollar price, except
for beef, which uses the Australian dollar price.
Sources: Bloomberg; MLA; RBA; Refinitiv.
Working in the other direction, services price inflation in Australia remains high, rents are increasing quickly and
there will be further large increases in electricity prices this year (Graph 6). In addition, unit labour costs are
increasing briskly, an issue I will return to in a few minutes. These developments mean that it is too early to
declare victory in the battle against inflation.
Graph 6
CPI Inflation
Select components, year-ended
% %
Market services Rents
9 9
6 6
3 3
0 0
% %
Electricity Administered prices
20 10
10 5
0 0
-10 -5
-20 -10
2015 2019 2023 2015 2019 2023
Sources: ABS; RBA.
The path back to 2-3 per cent inflation is likely to involve a couple of years of relatively slow growth in the
economy. Even so, as the Board navigates that path it is seeking to preserve as many of the gains in the labour
market as is possible.
One of the unsung positive side-effects of the policy response to the pandemic is a once-in-a-generation
improvement in the Australian labour market. Over recent months, a higher share of Australians have had a job
than ever before, and youth unemployment has been the lowest it has been in decades (Graph 7). There are very
tangible economic and social benefits to this. Our ambition is to return inflation to target while holding onto as
many of these benefits as possible.
Graph 7
Labour Market
% %
Youth unemployment rate
Employment-to-population
ratio
64 20
60 15
56 10
52 5
1983 2003 2023 1983 2003 2023
Source: ABS.
I want to make it clear, though, that the desire to preserve the gains in the labour market does not mean that the
Board will tolerate higher inflation persisting. There is a limit to how long inflation can stay above the target band.
The longer it stays there, the greater the risk that inflation expectations adjust and the harder, and more costly, it
will be to get inflation back to target. If inflation stays high, this will damage the economy and all Australians will
feel the effects.
Yesterday's decision to increase interest rates again was taken to provide greater confidence that inflation will
return to target within a reasonable timeframe. It follows recent information that has suggested greater upside
risks to the Bank's inflation outlook. Services price inflation is proving persistent here and overseas, and the recent
data on inflation, wages and housing prices were higher than had been factored into the forecasts. Given this
shift in risks and the already fairly drawn-out return of inflation to target, the Board judged that a further increase
in interest rates was warranted.
In making this decision, the Board had a detailed discussion of the slowdown in household spending and the
stresses on household finances from higher interest rates and rents. But it also considered the costs for
households and the economy of inflation staying too high for too long. It is in Australia's interest that we get on
top of inflation and we do so before too long. The Board will do what is necessary to achieve that.
As we make our decisions over coming months, there are a number of factors that the Board will be paying close
attention to. I would like to briefly discuss four of these.
The global economy
The first is developments in the global economy.
Economic growth in advanced economies is slowing as restrictive monetary policy takes effect. Even so, labour
markets have been surprisingly resilient, with unemployment rates still close to multi-decade lows. Headline
inflation is declining as COVID disruptions are overcome, energy prices fall and food price inflation eases. But,
concerningly, core services inflation is proving to be persistent. In six-month-annualised terms, it is still above
6 per cent in the United States and 5 per cent in the euro area (Graph 8).
Graph 8
Core Services Inflation
Six-month annualised
% %
United States Euro area
6 6
3 3
0 0
2020 2023 2020 2023
Sources: BLS; RBA; Refinitiv.
This persistence in services price inflation reflects the strong demand for many services and strong growth in
wages, against the background of weak productivity growth. One source of ongoing uncertainty is how quickly
services price inflation globally will moderate and whether the needed moderation will require further increases
in interest rates. It is noteworthy that interest rates are higher in the other English-speaking advanced economies
than in Australia and are expected to go a little higher still.
The other significant source of uncertainty for the global economy is the strength of the economic recovery in
China. The economic indicators for China were weak in April, after a strong initial bounce-back following the
easing of the COVID restrictions late last year (Graph 9). And consistent with an economy operating with a fair
degree of spare capacity, inflation in China is much lower than in the rest of the world. This has implications for
Australia, not just in terms of the prices of goods in world markets but also for the prices of our resource exports,
which have declined of late.
Graph 9
China - Economic Indicators*
index index
Retail sales
December 2019 = 100
115 115
100 100
85 85
% %
Headline inflation
Year-ended
4 4
2 2
0 0
-2 -2
2019 2020 2021 2022 2023
*
Seasonally adjusted by the RBA.
Sources: CEIC Data; RBA.
Household spending
The second consideration is the strength of household spending domestically.
In aggregate, growth of household spending has slowed since mid-2022 as the post-pandemic spending bounce
faded and both higher interest rates and the cost-of-living pressures began to bite. We expect that consumption
growth will remain subdued for some time for these same reasons, although stronger population growth will
provide some offset to this.
There is, however, ongoing uncertainty about the outlook for consumption given the large number of factors
influencing household finances and spending. Employment has been rising strongly, people have been getting
more hours of work and nominal income growth has been strong (Graph 10). These are all positives. In addition,
the headwind for household spending from falling housing prices looks to be coming to an end and could be
replaced with a tailwind from increasing housing prices. On the other hand, real incomes have declined and
required mortgage payments as a share of household disposable income will reach a record high later this year.
Many households will transition from low fixed-rate loans over the next few months and experience the increase
in repayments that has been occurring for variable-rate borrowers. Rents are also increasing quickly, putting
pressure on some households' finances.
Graph 10
Household Indicators
$b index
Retail trade values* Housing prices**
35 130
33 120
31 110
29 100
% m
90+ day arrears rates*** Employment
1.0 13.5
0.8 13.0
0.6 12.5
0.4 12.0
2019 2021 2023 2019 2021 2023
*
Three-month moving average.
**
January 2020 = 100.
***
Housing and personal loan arrears; there is a structural break in
March 2022.
Sources: ABS; APRA; CoreLogic; RBA.
Another complicating element is the very mixed experience across households and firms. Retail spending on
goods has been weak but spending on many services has held firm. And the data that the banks share with us
suggest that spending is most subdued among households with a mortgage, especially those that borrowed
large amounts relative to their incomes over recent years, and households that rent. At the same time, some
households accumulated large additional savings during the pandemic and have not run these down. Other
households have very limited savings and few financial buffers.
One of the other indicators we are monitoring closely is mortgage arrears. These remain very low, although they
have increased a little of late. Banks report that their customers are managing to make their mortgage payments,
although many have had to cut back on other spending. So, it is a complicated picture.
Given the importance of household spending to the overall economy, the Board will continue to pay close
attention to all these indicators.
Growth in unit labour costs
A third consideration that the Board is playing close attention to is the rate of growth in unit labour costs - that is,
the difference between growth in nominal labour costs and productivity.
This is because, over time, there is a close relationship between inflation and the rate of growth in unit labour
costs. Over the entire inflation targeting period, the cumulative increase in the CPI has closely matched that in
unit labour costs, although there have been periods of divergence (Graph 11).
Graph 11
CPI and Unit Labour Costs
March quarter 1993 = 100
index index
200 200
Unit labour costs*
175 175
150 150
CPI**
125 125
100 100
75 75
1993 1998 2003 2008 2013 2018 2023
*
RBA measure; adjusted for JobKeeper subsidies in 2020-2021.
**
Seasonally adjusted; excludes interest charges prior to the September
quarter of 1998; adjusted for the tax changes of 1999-2000.
Sources: ABS; RBA.
In recent times, unit labour costs have been increasing quite strongly (Graph 12). Over 2022, they increased by
around 71⁄2 per cent, which is one the largest annual increases during the inflation targeting period. While the
causation with inflation runs both ways, ongoing strong growth in unit labour costs would underpin ongoing
high inflation outcomes. The best way to achieve a moderation in growth in unit labour costs is through stronger
productivity growth, which would also underpin durable increases in real wages and our national wealth and
make more resources available to fund the public services that people value.
Graph 12
Inflation and Unit Labour Costs
Year-ended
% %
10 10
Unit labour costs*
5 5
CPI
0 0
-5 -5
2013 2015 2017 2019 2021 2023
*
RBA measure; adjusted for JobKeeper subsidies in 2020-2021.
Sources: ABS; RBA.
Unfortunately, growth in productivity has been weak over recent times. Indeed, the level of output per hour
worked in Australia today is the same as it was in late 2019. This means there has been no net growth in
productivity since then (Graph 13).
Graph 13
Labour Productivity
Non-farm GDP per hour, December quarter 2019 = 100
index index
100 100
95 95
90 90
85 85
80 80
2002 2006 2010 2014 2018 2022
Sources: ABS; RBA.
The reasons for this are not well understood.
Productivity growth was slowing before the pandemic and it is entirely possible that the disruptions caused by
the pandemic made things worse. Many firms had to focus on survival, rather than growing their business.
Supply chains were interrupted, there was both labour hoarding and labour shortages, investment was delayed
and finance tightened up. None of this was helpful for productivity growth. Offsetting this, there was innovation
as firms found new ways of working, but it is unlikely that innovation of this kind offset the detrimental effects of
COVID on productivity.
The uncertainty here, is what comes next. It is possible that with the pandemic now behind us, productivity
growth will pick up. Advances in science and technology, including increased digitisation and the use of artificial
intelligence, could also help. So too could further improvements in the way that services are delivered as well as
reforms to public policy. But there is considerable uncertainty here.
What is critical are the trends over time, not the outcomes from quarter to quarter. At the aggregate level, wages
growth is consistent with inflation returning to target provided that trend productivity growth picks up. Given the
importance of this issue and the increased risks on this front, the Board will continue to pay close attention to
trends in productivity growth and their implications for the sustainable rate of growth in nominal wages.
Inflation expectations
A fourth important consideration is inflation expectations. As I discussed earlier, if people expect inflation to stay
high, then it is likely to stay high. Firms will adjust their pricing behaviour and workers will seek bigger pay
increases to compensate them for the higher inflation.
Currently, measures of medium-term inflation expectations derived from financial market prices are around the
middle of the 2-3 per cent target range (Graph 14). The same is true for professional forecasters. This suggests
that financial market participants and economists expect that the RBA will be successful in containing inflation
over the years ahead.
Graph 14
Long-term Inflation Expectations
% %
Unions*
4 4
Inflation swaps**
3 3
2 2
1 1
1998 2003 2008 2013 2018 2023
*
Average over the next 5-10 years.
**
5-years to 10-years forward.
Sources: Australian Council of Trade Unions; Bloomberg; RBA; Workplace
Research Centre.
Measures of expected medium-term inflation for price- and wage-setters in the economy are, unfortunately,
more difficult to obtain. One measure is from a survey of union officials that the RBA has run for many years,
where we ask for the expected inflation rate over the next 5-10 years. This measure has increased significantly,
after being very low for a number of years, although it is at a level seen prior to the pandemic when inflation was
close to its target.
For households, the main data on inflation expectations relate to just the year ahead; we lack measures of
medium-term inflation expectations. Understandably, given the elevated inflation rate at the moment and the
forecasts for the next year, short-term inflation expectations are high at present. Due to the importance of
inflation expectations remaining contained, the Board will continue to monitor all these measures closely.
Finally, putting all this together, we remain on the narrow path but there are significant risks. We are particularly
attentive to the risk that inflation stays too high for too long. If that happens, expectations will adjust, high
inflation will persist, interest rates and unemployment will be higher and the cost-of-living pressures on
Australian families will continue. The Board is seeking to avoid this. Yesterday's further increase in interest rates
provides greater confidence that inflation will come back to target within a reasonable timeframe.
Some further tightening of monetary policy may be required, but that will depend upon how the economy and
inflation evolve. The Board will continue to pay close attention to developments in the global economy, trends in
household spending, and the outlook for inflation and the labour market. It remains resolute in its determination
to return inflation to target and will do what is necessary to achieve that.
Thank you and I am happy to answer some questions.
Endnotes
[*] I would like to thank David Norman for assistance in preparing this speech.
12 RESERVE BANK OF AUSTRALIA