Another thoughtful note from Westpac chief economist Luci Ellis, who seems to be relishing the relative freedom of expression since leaving her role as RBA assistant governor (economic) late last year.

She has again sent something of a riposte to those economists who believe interest rate rises can cure all inflation ills.

“Achieving a soft landing after a large shock cannot be left to one policy tool that operates unevenly across the community and is not well tuned to all kinds of shock,” she wrote.

Earlier this week, the Westpac consumer sentiment survey showed that households planned to save about 80 per cent of the tax cuts they are getting from July 1.

Westpac’s economists did add that plans often don’t translate to actions, so it’s likely that they’ll save less than that, but it seems clear a lot of both the tax cuts and energy subsidies will stay in people’s bank accounts (at least in the short term) and therefore not translate entirely and immediately into higher demand and inflation.

“That households plan to save more out of the extra income than in previous episodes should not come as a surprise. It is the expected implication of contractionary monetary policy,” Ellis observed, before providing an Economics 101 lesson to some others in her profession.

“One of the main ways that monetary policy dampens demand is by changing the incentive to save versus borrow or spend. It does not need to reduce people’s incomes to change their behaviour.

“The RBA minutes referred to this as ‘simply choosing’ to spend less, but there is no mystery behind the choice. It is what economists call the ‘intertemporal substitution channel’. People ‘simply choose’ to respond to the incentives created by higher interest rates.

“Intertemporal substitution is likely to be more powerful than the ‘cash flow channel’ working via lowering the incomes of households with mortgages, not least because it affects everyone.”

In other words, even though some people are actually receiving higher disposable incomes, because of rising rates, their incentives to save more of that income and spend less are also increased.

Ellis continued with a policy suggestion to set indexation of many regulated prices and values at 2.5% per annum rather than to the Consumer Price Index.

“One obvious improvement would be stop indexing administered prices such as education fees and subsidised medicines to the CPI. This simply propagates a surge in inflation into the following year. Indexing by 2½%, the midpoint of the RBA’s inflation target, would avoid this issue,” she argued.

“Another refinement that would improve the response to inflation surges would be to index tax brackets by 2½%,” she continued, reiterating an idea she’d flagged in a previous note.

“Indexing by 2½% would be preferable to CPI indexation in a range of other domains, too. Governments and others could build a preference for contract bids with escalation clauses fixed at 2½% annually, not CPI-linked indexation clauses.

“Capital gains could be taxed at the full marginal rate on a ‘real’ return using a 2½% annual inflation rate. This would remove the tax preference for capital gains over rental income – a significant distortion in the housing market – without the complexity of the pre-1999 system and without having to touch negative gearing.

“And all of these policy refinements would help anchor inflation expectations by keeping that 2½% figure front of mind.”