to turn to the board ’ s monetary policy decisions over recent months. the board is committed to doing what is necessary to ensure that inflation returns to target over time. high inflation is a scourge. it damages our standard of living, creates additional uncertainty for households and businesses, erodes the value of people ’ s savings and adds to inequality. and without price stability, it is not possible to achieve a sustained period of low unemployment. it is important, therefore, that this current surge in inflation is only temporary and that we once again return to the 2 to 3 per cent range. the board is committed to the return of inflation to target. it is seeking to do this in a way that keeps the economy on an even keel ; it is possible to achieve this, but the path here is a narrow one and it is clouded in uncertainty. i would like to highlight three sources of this uncertainty. the first is the global economic environment. in the united states, the federal reserve has indicated that a period of tight monetary policy and below - trend growth will be required to get inflation under control. in europe, real incomes are suffering very big declines because of sharply higher energy costs, and this will weigh on spending and growth. and in china, the economy is being affected by the authorities ’ approach to covid, major stresses in its property industry and drought in parts of the country. some slowing in the global economy will help bring inflation down, but a sharp slowing would make the job of delivering a soft landing here in australia much harder. the second source of uncertainty is domestic in nature – and that is how inflation expectations and the inflation psychology in australia adjust to the period of high inflation. if workers and businesses come to expect higher inflation, and wages growth and price - setting behaviour adjusts accordingly, the task of navigating that narrow path will be very difficult, if not impossible. a shift higher in inflation expectations will require higher interest rates. in time that would mean a sharper slowing of the economy. it is in our national interest that we avoid this. the third source of uncertainty is how households respond to higher interest rates. interest rates are increasing for the first time in 12 years and they are rising quickly. the full effects of this are still to be felt. household budgets are also under pressure from higher inflation, and housing prices are declining after large gains r e s e r v e b a n k o f au s t r a l i a ( graph 8 )

- 20 - 20 - 40 - 40 sources : abs ; rba while this lift in energy prices explains some of the surge in inflation, it is by no means the full story. we can make some further progress in understanding this surge by using the standard workhorse models of inflation, which explain inflation by inflation expectations and the aggregate output gap. strong demand at a time of impaired supply – and thus a closure of the output gap – certainly helps explain part of the recent higher inflation. but these models fall well short of explaining the magnitude of the lift in inflation and, in my view, face some real challenges. one of these challenges is that the focus on the aggregate output gap is insufficient in a world in which shocks are highly uneven across sectors. we need to pay more attention to developments in individual sectors. one of the distinguishing features of the past two years is that the shocks have been highly asymmetrical. in 2020 and 2021 there was a huge increase in demand for goods and a decline in demand for services. this was particularly evident in the united states, where the demand for goods surged by close to 20 per cent in less than a year and the demand for many services was weak ( graph 5 ). a similar, although less pronounced, pattern was evident in australia. r e s e r v e b a n k o f au s t r a l i a graph 5 consumption december 2019 = 100 index united states index australia goods services sources : abs ; rba ; refinitiv this surge in demand for goods occurred at the same time as the supply side was constrained. this was partly because covid interrupted production. but it goes beyond this. even in good times, the supply side would have had trouble coping with a 20 per cent surge in demand in a short period of time. just - in - time inventory management and long supply chains had made the system less resilient and less able to respond to rapid and unexpected shifts in demand. the result was that many industries quickly found themselves on the sharply upward sloping part of the supply curve, and prices increased. and there was no offsetting deflation in those parts of the economy where demand was weak. one lesson here is that what is happening at the sectoral level is important in influencing the overall inflation dynamics in our economy – it ’ s not just the aggregates that matter. [ 3 ] resources don ’ t move freely between sectors, which means that the composition of demand and supply is important, not just