Reserve Bank of Australia assistant governor Sarah Hunter warns of recession if inflation forces rate hikes

The Reserve Bank of Australia’s chief economist Sarah Hunter has warned entrenched inflation could force up interest rates and induce a recession.

In a speech about inflation and the Middle East conflict, she warned of inflation expectations leading to firms putting up prices.

“Moreover, if expectations rise persistently, it becomes harder for the central bank to bring inflation back to target, as it must both bring expectations back down and restore the balance between supply and demand,” she told the Bloomberg Forum for Investment Managers in Sydney on Tuesday.

“Doing so may require a more substantial slowing of economic activity, as we saw during the early 1990s recession.”

The RBA’s assistant governor for economic policy also suggested more price rises were likely as a result of higher fuel prices since the Iran war began in late February.

“Reports from our liaison program suggest that some firms have responded already, with fuel surcharges raised by firms at the start of supply chains that flow into a broad set of industries,” she said.

Ms Hunter also suggested Labor’s plans to build 1.2 million homes by mid-2029 would be difficult, given the sharp rise in construction costs.

“For example, some construction firms – who have been relatively highly exposed to transport and oil-derived raw materials cost increases – are reviewing prices for new contracts,” she said.

“This is particularly the case in regions where demand is still growing strongly and supply capacity is constrained, consistent with the findings of our recent research.”

Labor’s fifth Budget since coming to office in 2022 has also pushed 10-year government bond yields to 15-year high levels above 5 per cent with government payments set to make up 26.8 per cent of gross domestic product - the highest in four decades outside COVID.

“Government bond yields had also increased, particularly at longer maturities,” the Reserve Bank noted in the minutes of its May meeting released on Tuesday.

“These increases were largely driven by higher real yields: longer term inflation expectations had not risen noticeably across advanced economies, despite the increase in measures of near-term inflation expectations.”

By the end of the decade, Treasury is expecting gross government debt to hit $1.2 trillion, making up 35.8 per cent of gross domestic product.

Dr Hunter said Federal and State government spending were both adding to demand.

“We’re going to be putting all of that together to see what that looks like in terms of what’s happening to government demand and we’re also thinking about the tax side and how that might be changing,” she told Bloomberg TV.

The Reserve Bank a fortnight ago raised interest rates for the third time this year, taking the cash rate to a 15-month high of 4.35 per cent and undoing all the relief from last year.

The minutes of that meeting noted that one monetary policy board member, out of nine, argued one more rate rise in May would be unlikely to tame inflation.

“Members agreed that monetary policy could not prevent a near-term increase in the price level as higher fuel prices worked their way through to final prices,” it said.

The unnamed dissenting board member argued it would be better to wait and see before raising rates again, on top of the February and March increases.

“The member in the minority judged that there was not yet sufficient evidence to be concerned about longer term inflation expectations becoming less anchored, particularly in view of the board’s commitment to its inflation objective having been demonstrated by the 50 basis points of tightening already delivered this year,” the minutes revealed.

The annual pace of inflation in March hit a near three-year high of 4.6 per cent, during the first full month of the Iran war, and the RBA is now expecting it to hit 4.8 per cent by June.

Underlying inflation at 3.3 per cent was also above the RBA’s 2 to 3 per cent target, with the central bank seeing it reaching 3.8 per cent by mid-year.

“Putting this all together, our forecast for underlying inflation has been revised higher in the near term,” Ms Hunter said.

“Oil prices could stay elevated for longer than implied by market pricing, and the Iran conflict could lead to broader, more persistent supply disruptions, adding to inflation.

“Cost pass-through may also be stronger than assumed, and higher fuel prices could lift and embed higher inflation expectations, which RBA research shows are particularly sensitive to fuel, perpetuating the inflationary shock.”