There’s been a lot of talk about the implications of conflict in the Middle East on the economy, rightfully so.
The uniqueness of trade flowing through the Strait of Hormuz means global markets have already taken notice, and Australia, as a small open economy, will certainly be affected.
Understanding how the conflict could impact the economy, interest rates, and house prices is important, but it is equally complex. There is no point being overly futurist over how this conflict will play out; instead, we can try to understand directionally how the economy could move and what the Reserve Bank could do in response.
When the RBA hiked rates in March, the board wasn’t as concerned about conflict, as it was the stickiness of inflation domestically. Members noted that the economy was “at capacity”, meaning domestic supply was not keeping up with demand.
Headline inflation was 3.7% in the 12 months to February, and underlying was steady at 3.3%. While households tend to feel headline inflation more directly, as that is what they actually pay, the central bank prefers underlying inflation as a measurement tool of inflation.
Underlying provides a clearer indication of where inflation is heading because it removes temporary price shocks from the inflation that increase volatility, which are usually difficult to control and have an impact that declines rapidly. Both being above the target band is extremely concerning, right as an energy price shock is occurring.
When the RBA says, “at capacity”, they mostly mean non-tradable goods and services. This means prices of domestically produced goods and services - in essence, things we don't import from other countries. These prices are driven mostly by labour costs and/or policy settings, which include expenditure areas like hairdressing, pharmaceutical products, electricity and housing.
Non-tradable prices, which make up about 65% of the CPI basket, grew 5% over the 12 months to February. While tradable prices are mostly determined by international prices/competition, growth in those goods and services has grown only 1.3% and has been softer since December.
This price growth contrast points to the fact that the Australian economy is already struggling to produce goods and services domestically to meet our current demands.
Those domestic pressures are why the RBA hiked rates in March. So, what will a global energy price shock mean to the Australian economy, central bank and mortgage rates?
This conflict will not impact everyone uniformly when we consider Gross Domestic Product (GDP) as a preferred measure of the economy. GDP is a calculation based on Consumption + Investment + Government Spending + (Exports – Imports).
Initial modelling indicates that there will be minimal impact on GDP, but that would be mostly due to net exports (exports less imports) increasing because of higher export prices for Australia, helping to offset declines in consumption and investment.1
The reason that net exports tend to rise is that when a global oil price shock occurs, other energy prices tend to rise, such as gas and coal. Coal and gas are actually Australia’s second and third-largest exports, which, in dollar terms, bring in three times as much revenue as Australia spends importing refined petroleum. This means that, in general, the oil price increase must be at least three times the growth of gas and coal prices to negatively impact net exports.
That’s positive news for export energy companies - more profits - but households tend to experience a different story. Consumption is the part of the economy where household spending mostly exists, and that won’t fare as well.
As a household, there are two ways to think about the Middle East conflict economically: first, in the short term, the direct impacts include a price shock across several goods households consume, mainly petrol and diesel.
The demand for automotive fuels tends to be inelastic, meaning an increase in prices has a smaller relative impact on demand. You need to fill up a certain amount to get where you’re going, which for a lot of people won’t change because of the price. So, for households, this results in a decline in disposable income.
This also means the recent halving of the fuel excise brings forward demand, potentially adding to price pressures in the long term.
The next factor is the more indirect impact that reverberates through increased costs to firms that produce other goods and services. Like what happened during the pandemic, this pushes up consumer prices as producers’ input prices rise and businesses are unable or unwilling to absorb the cost increase.
This price flow-through to consumers further compounds inflationary pressures, building on already elevated levels, putting downward pressure on real incomes and consumption.
It’s important to go back to the RBA’s mandate, which, following a recent review, was more explicitly laid out as trying to achieve price stability and full employment. Full employment is defined as “the current maximum level of employment that is consistent with low and stable inflation.”
The definition of 'full employment' can change, and is not explicitly laid out; it tends to be around the mid-4% range, though the figure is constantly debated. Unemployment is currently at 4.3% and is softening slightly, yet inflation is still running hot - this may shuffle the definition of 'full employment'.
The RBA has stated that it will balance the two objectives and will not give equal weighting to the objectives. Inflation and unemployment empirically have an inverse relationship; that is, when one goes up, the other tends to go down. We saw this during the pandemic: inflation rose, and unemployment declined. So, the RBA has to make some trade-off between them.
In the review, the bank also noted that, as is well known, the cash rate setting affects aggregate demand. Aggregate demand in an economy is represented by GDP, as discussed earlier with the same equation.
That is, the demand for goods and services of the whole Australian economy is equal to Consumption + Investment + Government Spending + (Exports – Imports), the same as GDP. An increase in the interest rate decreases consumption and investment by increasing the cost of borrowing and decreases net exports by appreciating the Australian dollar, making imports more costly. It also sends a price signal to save, rather than spend, which withdraws money from the economy.
Hence, when supply-side shocks occur, a change in the ability of the whole economy to supply goods and services, it is difficult for the RBA to tame inflation as it can only influence the demand side of the equation, at least in the short term.
This means that the RBA can only use interest rates to slow demand and ‘wait’ for supply to catch up, slowing growth.
But is it the RBA’s job to worry about growth? They mostly only have one tool to affect the economy: the cash rate.
The RBA will prioritise “low and stable inflation” over any sort of growth concerns. If the central bank increases interest rates, that could slow the economy into an economic decline, which will most likely result in lower inflation. With a signal of low inflation, rates can be cut, stimulating the economy.
Aside from actual price growth, the central bank will also be concerned with inflation expectations - how households perceive future price growth - which recently reached 6.7%.2
The RBA knows from its own research that oil price shocks have a greater impact on inflation expectations than the ‘average’ item price shock,3 even as automotive fuel makes up only 3.4% of the CPI basket. Consumers tend to shift expectations more dramatically to automotive fuel changes than to price changes in other goods.
The problem with high inflation expectations is that they create a reinforcing cycle: if you expect prices to rise in the future, your preference for buying now increases. If that occurs across the economy, then demand will be brought forward, and prices will increase, even if the costs haven’t increased.
We saw a brief example of this in the first week of the Iran conflict. Consumer expectations that fuel prices would increase led them to buy more. Retailers didn’t have on-site capacity to supply in the short term, so prices increased. That expectation can be almost as bad as the actual price increase because of this cycle.
The combination of higher inflationary expectations and actual higher prices is bad for the Australian economy. Inflation hurts everyone and has implications for prosperity, so the RBA will know its role in all of this. Thankfully, we’ve had scenarios like this previously, and lessons from the past will guide the RBA’s thinking and decisions.
In the short term, we can probably expect cash rate increases to dampen both the domestic drivers and higher expectations. Once the RBA is satisfied that those are at a reasonable level, or returning towards target, the question will be whether they should still be as concerned about the oil shock.
Oil price increases can slow global growth. Some economists argue that oil supply shocks combined with contractionary monetary policy, increasing interest rates, is the worst thing to do when an oil supply shock occurs, as it is a double hit to growth.
Australia, luckily, is traditionally protected by our export capacity and terms of trade. Additionally, most households currently have positive equity in their property - as in, the home is worth more than what is owed to the bank.
Even if property prices declined by 30% - seven-times larger than the downturn we saw in 2022 - 90% of households would still be in positive equity. So, the central bank will have greater confidence that higher rates shouldn’t have a major impact on loan defaults and household financial stress.
Ultimately, the RBA faces a significant challenge, which will be unpopular no matter the decisions, but this is where the 1700-odd staff earn their money. We know that the RBA will be focused on inflation, potentially at the expense of growth and employment. The unfortunate reality is that higher oil prices make the trade-off the RBA faces harder, which means higher rates.
