There are three main reasons inflation is rising. Higher rates won't fix them

Bloodletting is an ancient therapy, dating back at least three millennia, and traditionally used to "cure" a range of ills.

Whether through leeches or lancets, blood was drawn from the patient to rebalance their humours with the hope of a cure.

But the outcomes were no laughing matter for many unfortunates.

Perhaps most famously, the USA's first president George Washington had more than one-and-a-half litres of blood removed in an attempted cure for epiglottis that likely caused, or at least hastened, his death in 1799.

Fortunately for us, the practice fell out of favour as medical science progressed in the 19th century, and is now restricted to a few specific diseases where it has been shown to help.

Unfortunately, the economic equivalent of bloodletting remains the treatment in vogue whenever inflation is the symptom, whatever the underlying cause of the disease.

That panacea is higher interest rates. Draw money out of the economy by jacking up the cost of debt and the patient will recover … if the treatment doesn't kill them.

Rate rises don't fix supply problems

Last week, the Reserve Bank's deputy governor Andrew Hauser told 7.30 that Australia's economy has "one big problem and that's inflation".

Echoing words from his boss at her last press conference, Hauser told Sarah Ferguson that:

"Inflation has been above target for a long period of time and, at some point, we will have to say that is long enough."

And, if we get to that point, what's the solution?

"We will raise interest rates further than otherwise we would need to do so," the central banker responded.

"We're not at that point yet, but some of these upside risks to inflation are certainly on our mind."

So what exactly are these "upside risks" that could mean inflation is higher and more stubborn than the RBA's existing forecasts? Hauser listed three.

"One is the Middle East and the ongoing crisis there, one is a really unexpected global boom driven by AI, and one is the weakness of the supply potential of the Australian economy," he said.

Will higher Australian interest rates influence any of those things? No.

The US and Iran will not stop attacking each other because Australian mortgages have become more expensive.

The money behind the AI boom is mainly coming from US multinationals, so higher local rates are likely to make little difference to investment in that sector.

And higher rates are more likely to weigh on the supply capacity of the Australian economy rather than grow it, as they send some businesses broke (handing their surviving rivals more pricing power) and discourage firms from borrowing to increase capacity and productivity.

As CBA's chief economist Luke Yeaman explained on The Business last week:

"The economy is slowing, but not fast enough for their liking, and an extra rate hike now could help drive that growth down lower and bring it more in line with the supply capacity of the economy."

Hence the analogy with bloodletting. Rising rates mainly lower inflation through destroying demand, hopefully more quickly than they reduce supply.

Are Australian home owners paying for the AI boom?

A lot of column inches have already been devoted to the role that the Middle East conflict and Australia's productivity crisis have played in our lingering inflation problem.

However, it is telling that the RBA has elevated the AI boom alongside those issues.

Hours before Andrew Hauser appeared on 7.30, the Reserve Bank's chief economist Sarah Hunter spoke at an AFR property summit.

She said the bank was hearing anecdotes about workers being sucked in, at inflated wages, to build new data centres, adding to cost pressure across the construction sector.

"They want these centres built really rapidly, as fast as possible in some cases, and it's definitely adding to demand," she said.

"You can see business investment has picked up really strongly over the last sort of nine months or so, nine to 12  months, double-digit growth, and a decent chunk of that is data centres."

Research from the Committee for Economic Development of Australia (CEDA), released last week, shows business investment spending is at 12.6 per cent of GDP, its highest level in more than a decade, since the mining boom wound down.

CEDA economist Julie Toth said the boom was being almost entirely driven by the information, media and telecoms sector as businesses ramped up their investments in data centres, cloud computing and artificial intelligence infrastructure.

Investment in this sector almost doubled over the past year.

Comparisons to the mining boom are apt.

Just as the investment in that sector, concentrated in WA and Queensland, contributed to interest rates rising around the country, resulting in a two-speed economy earlier this century, the AI boom will inflict pain across other sectors.

With most economists seeing the economy running above capacity, as evidenced by inflation, all the demand being added by data centre construction has to be offset by the RBA raising rates to smash activity in other areas.

As with the mining boom, much of the benefit from the AI boom will likely be captured by overseas shareholders of the multinational companies driving it, while the costs will be borne domestically through higher interest rates and slower growth in other sectors.

Is the public 'furious' with inflation or angrier with the RBA?

That brings us back to interest rates, and the RBA's tricky decision about whether to hike in two weeks or not.

Markets are pricing in at least a 75 per cent chance that the cash rate will go up to a 15-year high of 4.6 per cent on September 29.

They are pricing in a virtual certainty of two rate hikes by February, with a 50/50 chance of a third by mid-next year.

A cash rate of 4.85 per cent would be the highest since rates were slashed over late 2008 in response to the global financial crisis.

Andrew Hauser said getting on top of inflation was not only the bank's primary mission, but the community's expectation.

"People are furious about inflation," he said on 7.30.

"It's the most profound message that we get. Everywhere I go, I hear cost, cost, cost, inflation, inflation, inflation. And that's our responsibility. We have to put that right."

The RBA's own community survey shows he's right, with two-thirds of people putting it as one of their top three economic concerns.

But the same survey turned up another finding that has the Reserve Bank worried. They see the RBA as part of the inflation problem, not as the solution.

"Only 25 per cent of respondents assessed correctly that higher interest rates would ultimately lead to lower inflation, while more than half indicated that higher interest rates would lead to higher inflation," the report lamented. 

And statements like this from the Reserve Bank governor are unlikely to help those public perceptions.

"People who have mortgages at least, they see increases in interest rates as an increase in the cost of living, but it's not really," she said in response to my question at a business economists lunch in July.

"So interest rates are the response to high inflation, they're not causing high inflation."

While mortgage repayments may have been deliberately excised from the Consumer Price Index in the late 1990s at the RBA's request, they are a very real cost of living for anyone with a mortgage.

It's no wonder then that a constant refrain in interactions with our audience when we're covering interest rates is, "Surely there's less painful and more effective ways to lower inflation?"

And there potentially are. I wrote about some of these ideas back in May.

But while governments continue outsourcing inflation management to unelected technocrats at central banks, the economic bloodletting is likely to continue.