Read the article below and answer the following questions.

Australia, get ready for higher interest rates

Stephen Koukoulas

Tue, 19 October 2021

For the first time in many years, central bankers and global investors are witnessing amaterial pick-up in inflation. Despite the evidence, which shows inflation lifting to levels well above target, the reaction of central bankers and investors has so far been muted. Some central banks have started to hike interest rates in reaction to the inflation pressures. Near to home, theReserve Bank of New Zealand lifted its ratesearlier this month to 0.5 per cent. Some others in South America and Eastern Europe have hiked interest rates in reaction to the acceleration in inflation. Markets are now openly canvassing the prospect of higher interest rates in the US, Eurozone, the UK and Canada, among many others, perhaps within the next few months.

In Australia, the RBA has largely dismissed these pressures signalling that, on its assessment, inflation will remain low and it will not be required to hike interest rates until 2024, at the earliest. Markets are ignoring this guidance, with the start of the interest rate hiking cycle starting to be priced into the later part of 2022, just 12 months from now, and around two years before the RBA reckons it will need to move. Recall the current official cash rate is 0.1 per cent. The market is pricing in a 0.5 per cent cash rate by the middle of 2023, 1.0 per cent by the end of 2023 and with further increases through 2024.

If these rate hikes unfold broadly as the market suggests, it will be after the RBA ends its bond buying program and the 0.1 per cent yield target for government bonds dated out to April 2024. Such a constructive policy change will only add to the upward momentum in bond yields which will inevitably filter into mortgage interest rates, especially for fixed rate products. It is likely to show a further increase in inflation which the RBA has not anticipated. Indeed, the annualised increase in underlying inflation is likely to edge above 2 per cent, a move that will see the Bank revise up its inflation forecasts in the Quarterly Statement on Monetary Policy which is scheduled for release in early November.

At its next Board meeting, on Melbourne Cup day, the RBA needs to ask whether a 0.1 per cent cash rate, aggressive bond purchases and a 0.1 per cent target for what are now 2-and-a-half year government bonds is consistent with the economic and inflation outlook. At that meeting, the RBA would be wise to start flagging the end to all of these policies and to layout an up-to-date and realistic timetable for what will be an inevitable tightening in monetary policy.

It can easily scale back and then turn off the bond buying program. So too for the target for the April 2024 bond which it can slowly step away from, allowing those yields to be driven by the market. In terms of hiking the official cash rate, the RBA needs to signal to the market that inflation pressures have been more acute than it was forecasting even a few weeks ago and it will follow the lead of other central banks pointing to the need for higher interest rates in the months ahead.

Not only would this be prudent from an overall inflation management perspective, but it might have the benefit of cooling demand for credit which has fuelled the recent boom in house prices. Such a move would be more powerful than the recent decision of APRA to tighten the lending rules for mortgages. There are two meetings of the RBA Board before the recess from early December 2021 through to early February 2022. These are the windows for it to be proactive in its policy guidance and strategy and to signal, well in advance that the days of easy money are about to end.

a) According to the article, what is the current official cash rate in Australia?

What are the forecasted cash rates for 2023 and 2024?

b) According to the article, what needs to be done by the RBA to unfold the rate hikes?

c) According to the article, provide two reasons to support the implementation of tightening monetary policy by the RBA?

d) Explain how expansionary and contractionary monetary policies could be implemented? Mention the open market operation, changes in the money supply, and changes in the interest rates.

e) "Indeed, the annualised increase in underlying inflation is likely to edge above 2 per cent, a move that will see the Bank revise up its inflation forecasts in the Quarterly Statement on Monetary Policy which is scheduled for release in early November". Explain one argument supporting the inflation targeting by the RBA?