Economist delivers 'worst-case scenario' on interest rates as inflation fails to cool

Australia has a dirty little secret.Despite four Reserve Bank interest rate hikes, supposed fiscal restraint, and a recent small improvement in productivity, inflation is rising.At face value it makes no sense. Millions of households continue to struggle to make ends meet.Dig a little deeper though and the logic of why the country continues to struggle with inflation is painfully simple.There's simply too much money chasing too few goods and services.There appears to be only one solution: lower demand to the point where the economy breaks.Moving pieces of economic puzzleTo understand Australia's inflation problem, look no further than the Reserve Bank's commentary.Following its most recent decision to raise the cash rate, the RBA's statement began by saying that inflation was already too high.It went on to say "… and some of the upside risks flagged in August are materialising"."The conflict in the Middle East has broadened and global energy prices are now much higher than had been assumed in the August forecasts," it wrote."AI-related demand is driving rapid growth in global prices for technology-related goods."And there remains pressure on domestic capacity."Put simply, the economy is struggling to supply the goods and services to meet current demand, and higher energy prices add to the cost-of-living pain.The solution then is to boost the nation's ability to meet demand.Failing that, demand needs to come down.Inflation slipping away from usThere was better news on the supply front delivered in the most recent national accounts, where GDP per hour worked (one measure of productivity) moved out of negative territory, albeit to zero.But over the year, it sits at -0.2 per cent.Lacklustre productivity means the only option that remains, in the near term, is for demand to fall.Federal Treasurer Jim Chalmers said on Wednesday the government was doing its bit."We've been able to manage the budget in a much more responsible way than it was being managed by our predecessors … we accept our part in the fight against inflation," he said.And while private (or business) investment did not contribute to GDP in the June quarter, it was driven by household consumption (+0.2 percentage points).It has put a target on the back of households as the ones to blame for the "excess" demand.Iran war making inflation stickyAnd this is the critical point. The Iran war is squeezing oil supplies and forcing fuel prices higher.The Reserve Bank says its liaison program shows businesses are looking to pass increased costs of production into customers.Worse still, as RBA deputy governor Andrew Hauser said this week, is that businesses don't really see an end in sight to elevated costs."There's just some sign that some companies might be thinking, you know what, maybe prices aren't going all the way back."And if they're not, we're going to have to take that into account with the pricing decisions."This paves the way for his "nightmare" central banker scenario of unanchored inflation expectations.Sledgehammer to demandOne way to put this vicious cycle into reverse is to ensure consumers do not have money in their pockets to spend, or at least not as much money.Hence interest rate rises taking money out of consumers' pockets.So rather than supply not meeting demand, demand is unable to meet supply.Economic theory tells you prices then stop rising and actually fall.Why? Because business owners are forced to lower their prices to attract customers back to their stores.To be fair, the Reserve Bank has tried to set this path in motion, but its "cautious" approach has proved too cautious.But if households spend less to the point that the corner store does not replace a leaving staff member, the person who would otherwise have landed that job purchases fewer items and saves more … and so on.Alan Oster is warning Australia may face more interest rate rises next year, which could tip the country into recession. (ABC News: Sean Warren)This environment has the potential, former NAB chief economist Alan Oster says, so push the unemployment rate beyond 5 per cent.But interest rates need to rise higher for this to occur."My worst-case scenario would be two or three further rate rises, which I think would clearly cause you recession," Mr Oster said."And I think you're probably going to struggle anyway."Certainly, I'd expect, I'll wait until they've actually done it before I review my forecast, but I would expect to see lower growth and higher levels of unemployment and probably unemployment with the five in front of it," he said.So will rates keep rising?Betashares chief economist David Bassanese does not think the RBA will need to hike interest rates beyond November, but concedes Australia would likely enter a recession if it did."All up, my base case is that RBA will raise rates next week but then leave rates on hold at the last meeting of the year in December — providing households at least a small pre-Xmas reprieve," he said."Given gathering signs of weakness in the economy, particularly the very weak outlook for house prices, my expectation is the RBA won't need to raise rates further in 2027, though the risk still lay firmly to the upside."Should rates need to rise even further next year, the risk of recession would no doubt intensify."The number of interest rate hikes from here, says State Street Investment Management economist Ma Krishna Bhimavarapu, will depend on how much weaker the economy gets in coming months."We still expect the cash rate to ultimately have a 5-handle, but the path from here will depend on how quickly the economy slows," he said.The nation faced two options 12 months ago: improve productivity or else.The exogenous shock of an oil-sensitive war made the need to improve productivity an urgent one, but we've missed the boat.The Reserve Bank is now left with the unenviable task of taking a sledgehammer to demand for the greater good.Let's be honest, it's positively sinister, as are most dirty little secrets.