RBA's Limited Power: Interest Rates Can't Fix Everything

Australia is bracing for another interest-rate decision from the Reserve Bank of Australia (RBA), but many of the forces driving inflation are beyond the central bank's control.

The RBA can change interest rates, which has a ripple effect throughout the economy. Higher interest rates make borrowing more expensive, reducing consumer spending and investment. Lower demand should, in turn, reduce pressure on prices.

However, interest rates are not a panacea for all forms of inflation. Fuel prices, for instance, behave like a tax on economic activity, as money spent filling up a tank cannot be spent elsewhere. Higher fuel costs also become embedded throughout the economy due to supply chains and transportation costs.

The RBA itself recognizes the problem of external shocks, such as the Middle East conflict and associated energy shock, which have increased inflation risks while threatening economic growth. The central bank must balance raising rates aggressively, risking unnecessary economic weakness, versus doing too little and allowing temporary price increases to become embedded in wages and expectations.