‘The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that’ - Reserve Bank of Australia Governor Philip Lowe, statement 7 February.

Reserve Bank of Australia (RBA) board member and Dean of the Melbourne Business School Professor Ian Harper believes Australia has a good chance of navigating the "narrow path" leading to lower inflation while not plunging the economy into recession.

Professor Harper addressed the Athenaeum Club on Tuesday 28 February outlining the reasons behind the RBA's recent aggressive lifting of interest rates in order to tame inflation. His address was titled 'Taming the Inflation Tiger'.

Speaking personally and not on behalf of the board, Professor Harper said many economic commentators believe inflation has peaked at 7.8 per cent, with bank forecasts showing the same peak.

However, Professor Harper said the "rate at which we're likely to fall away from the peak could vary significantly".

"There is a significant degree of confidence that we have seen the peak in headline inflation. But how rapidly (it comes off) is a matter of conjecture but we are confident it will head downwards," he said.

With the cash rate currently sitting at 3.35 per cent (up from a low last May of .1 per cent), Professor Harper said the market expectation suggests a further two increases in the cash rate this cycle which would see the cash rate peak at 3.85 per cent.

Based on securities trading, Professor Harper said "Some think it will go above four (per cent) and come back again".

He stressed these were market predictions and not his own.

He conceded that taming inflation was not just about increasing rates to suppress demand.

Professor Harper said inflation took off in late 2021 through 2022, predominately because of supply side forces - the war in Ukraine, which pushed up energy prices, and China's efforts to aggressively suppress COVID-19.

"While the majority of the impetus is still on the supply side, and therefore out of the control of the Reserve Bank, there are still demand side forces interacting with the supply to produce this outcome," he said.

Professor Harper said the RBA and governments deliberately stimulated demand during the pandemic to "avoid a severe downturn in the economy".

"It then set about reducing the demand side stimulus but by then supply side factors had taken over. Since then the Reserve Bank, and other central banks, have been withdrawing demand side stimulus.  (Governor) Lowe's 'narrow path'."

Professor Harper said it will be 2024, or possibly 2025, before the RBA target range for inflation is reached.

"Even if we get a favourable outcome on inflation, the expectation is that inflation will still be at the top of the RBA target range into 2025."

Professor Harper said the RBA expects inflation to come off its peak "relatively slowly depending on how fast the economy slows".

He said growth was the "other aspect of the governor's narrow path".

"Yes we are trying to slow the economy, but if we do it too severely it could knock the economy into recession.

"The bank is not simply targeting inflation irrespective of what means for employment and growth.

"The expectation is we will walk that narrow path and avoid recession."

He said this expectation was backed by long term (10 year) indexed bonds which are anchored to an inflation prediction of 2 to 2.5 per cent.

Professor Harper said models were telling the bank that the economy will slow and avoid recession, but there was also a "positive probability" that the bank might be wrong and the economy slows much faster than anticipated.

A faster slowing could be prompted by external forces affecting Australia such as China failing to stimulate their economy or a weaker than expected USA.

"The bank believes we won't go into recession, but there is a possibility that it could be wrong and (Australia) falls into negative growth for a couple of quarters."

Professor Harper said an unavoidable consequence of a slowing economy was a rise in unemployment, but he said the rate of those without work would still remain "significantly lower" than in recent years and below the "natural rate" of 4.5 to 5 per cent.

When it comes to wages, Professor Harper said wages had increased on the back of a strong labour market, but conceded real wages will fall between now and when inflation comes back into the target range.

"Real earnings are still set to fall but if inflation does come off, that situation will turn but not for another year or so," he predicted.

"Wages are not driving inflation, it's supply side exacerbated by loose monetary policy put in place during the pandemic."

PROPERTY MARKET

Professor Harper said the downward turn in property prices in all capital cities will have an impact on consumption.

"Yes, house prices are coming off but coming off prices that were extremely high," he said.

Professor Harper said with some small pockets of exception, the bulk of households who borrowed money for housing are still well ahead of the interest rate rises. The savings rate is still higher than it was prior to pandemic and people are still making net contributions to their mortgage offset accounts.

"Those with the highest debt are those with the highest assets and they are continuing to pump money into offset accounts," he said.

He said the situation was similar for the estimated 800,000 mortgage holders due to come off fixed rates in the middle of this year.

The wealthy ones anticipated the change from fixed to variable rates and he said the number of households at the margins who might be put under financial pressure is very small according to RBA research.

Professor Lowe said soaring rental costs were a supply issue exacerbated by immigration picking up and planning laws allowing for "too few houses either to be owned or rented relative to demand".

He said Australia was well positioned relative to other advanced economies to weather the current economic turmoil. He said the USA had a more difficult task and was rising rates even more aggressively than the RBA and needed to do more, while inflation in the UK was more than 10 per cent leaving them a "mountain to climb".

Professor Harper said he was optimistic that inflation hasn't broken out in Australia and "we are clinging to the Governor's narrow path."

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