How the RBA’s inflation-targeting regime benefits the banks at the expense of households
Westpac, one of Australia’s big four banks, has announced an annual profit of $7.2 billion for 2022-23, up 26% on 2021-22. This impressive result comes as no surprise to the millions of Australian families who are struggling with higher mortgage rates and rising living costs. Westpac achieved this profit boost even though, for most of the year, many households were still benefiting from fixed-rate mortgages at low rates, which are only now expiring. It seems highly likely that next year will be even better for Westpac and the other big banks, as they can expect to set new profit records after a long period of low interest rates and relatively weak profits.
Westpac’s massive profit should also not surprise the Reserve Bank of Australia (RBA), the country’s central bank. In June this year, the RBA published a discussion paper looking at the impact of interest rates on bank profitability, which starts with the observation that “there is widespread empirical support that lower interest rates are associated with a decline in banks’ net interest margins” (that is, the difference between the banks’ own cost of funds and the rate they charge to borrowers). The RBA plays down this finding, arguing that banks may find ways to maintain profitability in a low-interest environment. But as far as ordinary households are concerned, it’s the margin between the return on savings and the cost of borrowing that matters.
It’s easy enough to see that higher interest rates help bank profits and harm borrowers. But interest rates go down as well as up. If the RBA were a neutral umpire, managing the economy to maintain stability in a way that benefits all of us, we could be comforted by the idea that the ups and downs will balance out in the long run.
But the RBA is far from neutral. Like other central banks, it is committed to an inflation-targeting regime based on the idea of the Non-Accelerating Inflation Rate of Unemployment (NAIRU), also called the “natural rate of unemployment”. This is, supposedly, the unique rate of unemployment consistent with low and stable inflation.
Why the NAIRU is a flawed and harmful concept
As the Labor government’s employment white paper recently observed, the NAIRU has several shortcomings as a measure of full employment. It evolves over time, is difficult to measure and does not capture the full potential of the workforce. Moreover, the NAIRU-based inflation targeting regime serves to enhance the power and prestige of central banks, and of the financial sector as a whole. On the other side of the coin, the inflation-targeting regime has been part of the process by which the wage share of national income has been pushed down over the last three decades. What’s good for the RBA is not necessarily good for Australian workers.
The RBA’s inflation target is set at 2-3%, which means that it aims to keep the annual increase in the consumer price index (CPI) within this range. The CPI measures the average change in the prices of a basket of goods and services that households typically buy. However, the CPI does not reflect the actual cost of living for many households, especially those with mortgages, rents, childcare, education, health and other essential expenses. The CPI also does not account for the quality and availability of public services, such as health, education, transport and infrastructure, which affect the well-being of households.
The RBA’s inflation target is based on the assumption that there is a trade-off between inflation and unemployment, and that keeping inflation low and stable is the best way to promote economic growth and welfare. However, this assumption is not supported by empirical evidence or theoretical logic. In fact, there is no clear and consistent relationship between inflation and unemployment, as different factors can affect both variables in different ways and at different times.
For example, inflation can be caused by external shocks, such as changes in oil prices, exchange rates, taxes or tariffs, which have nothing to do with the level of unemployment or the state of the labour market. Similarly, unemployment can be caused by structural changes, such as technological innovation, demographic shifts, environmental policies or social preferences, which have nothing to do with the level of inflation or the state of the money supply.
Furthermore, keeping inflation low and stable is not necessarily the best way to promote economic growth and welfare. In fact, low and stable inflation can have negative effects on the economy and society, such as:
- Reducing the real value of debt and increasing the burden of repayment for borrowers, especially households and small businesses, who are more likely to have variable-rate loans than large corporations and financial institutions, who can access cheaper and more stable sources of funding.
- Reducing the real value of wages and eroding the purchasing power of workers, especially those with low and fixed incomes, who are more likely to spend their income on goods and services than save or invest it.
- Reducing the real value of public spending and undermining the provision of public goods and services, especially those that are essential for social and environmental well-being, such as health, education, welfare, infrastructure and climate action.
- Reducing the real value of tax revenues and increasing the fiscal deficit and debt, which can limit the scope and effectiveness of fiscal policy and increase the reliance on monetary policy, which is less democratic and more prone to capture by vested interests.
How the RBA’s policy choices favour the banks over the households
The RBA’s policy choices reflect its bias towards the banks and the financial sector, rather than the households and the real economy. The RBA has been reluctant to use unconventional monetary policy tools, such as quantitative easing (QE), negative interest rates, or direct lending to the government, which could have helped to stimulate the economy, reduce inequality, and support public investment. Instead, the RBA has relied on conventional monetary policy tools, such as the cash rate, the term funding facility, and the yield curve control, which have mainly benefited the banks and the financial sector, by lowering their cost of funds, increasing their net interest margins, and inflating their asset prices.
The RBA has also been quick to raise interest rates in response to the recent rise in inflation, which has been largely driven by temporary and transitory factors, such as the rebound in demand after the Covid-19 lockdowns, the supply chain disruptions caused by the pandemic, and the base effects from the low inflation in 2020. The RBA has ignored the fact that the rise in inflation has not been accompanied by a rise in wages, which remain stagnant and below the RBA’s own expectations. The RBA has also ignored the fact that the rise in interest rates will have a disproportionate impact on the households, who are already facing high levels of debt, low levels of savings, and rising costs of living.
The RBA’s policy choices have effectively transferred wealth and income from the households to the banks, and from the real economy to the financial sector. The RBA’s policy choices have also increased the risks of financial instability, inequality, and social discontent. The RBA’s policy choices have failed to deliver on its mandate of promoting the economic prosperity and welfare of the Australian people.
