War on inflation might be going too far: economist

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While the outlook for the economy remains reasonable, the risk of Australia heading into recession in 2009 is rising as the Reserve Bank of Australia gets tougher against inflation, according to a leading economist.

AMP chief economist Shane Oliver said in his report that while the RBA is no doubt employing an element of jawboning to try and get Australians to slow their spending, "with interest rates going higher and higher, the risk that they go too high - if they haven't already - resulting in a hard landing in 2009 is becoming increasingly significant".

Hard landings - otherwise known as recessions - occur when the economy goes directly from a period of expansion to a recession as the government attempts to slow down inflation. This happens when the monetary policies are more restrictive or too tight than what is appropriate for the economy.

Minutes of the RBA meeting indicated that the Bank is increasingly uncomfortable with the inflation outlook and had actively considered raising the interest rates by 0.5%. The Bank finally opted for a 0.25% rate increase on the grounds that further policy tightening could be implemented in coming months. Many economists are already forecasting another rate hike to come as early as March and another one in May.

"The pressure on Australian households is now likely to be pretty intense," said Oliver. "Our concern remains that the RBA will end up going too far on interest rates, if it hasn't already, with households and consumers bearing the brunt of the pain."

Oliver explained that one of the reasons why interest rates have not yet had the desired impact is due to the tax cuts and wealth gains from the stock markets. "While the recent rate hikes haven't yet had the desired impact in slowing growth and inflation, it doesn't mean that they'll just keep rising with no impact. The longer and higher interest rates rise, the greater the risks," he said.

Oliver cited the last two tightening cycles in the late 1980s and early 1990s to illustrate just how hard it is to know where the "tipping point" for the economy is, with respect to interest rates.

"Between January 1988 and November 1989, the cash rate was increased from 10.6% to 18.2%, and mortgage rates rose from 13.5% to 17%. For most of these periods there was little apparent impact, with growth remaining strong, unemployment continuing to fall and inflation rising. Then suddenly, in late 1989, the economy began to falter, and by the time the RBA started cutting rates in January 1990, the economy was already in recession!"

With mortgage stress at record levels and continuing to affect a growing number of households, housing finance is already showing signs of softening, according to Oliver.

"There's increasing evidence that the tipping point may have been, or [is] close to being, reached," he said.

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