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Reserve's quest for happiness

By Henry Thornton - posted Tuesday, 6 March 2007


The graph plots Henry Thornton's Reserve Bank happiness index against the cash rate, which is of course the bank's chief policy weapon.

Low inflation implies Reserve Bank happiness, and in the happy zone we distinguish mild happiness (1 point) or strong (2 points).

If inflation is rising to levels close to the top of the Reserve's target band we assign either unhappiness (-1 point) or severe unhappiness (-2 points), depending on the strength of the bank's comments on the matter. Neutral is zero, naturally.

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For unemployment the story is similar. Low and falling unemployment implies happiness (1 or 2 points) while high and/or rising unemployment results in mild (-1) or severe (-2 points) unhappiness. We assign scores based on the commentary in the quarterly review, and this makes an index with a 9-point range. (Details of the index are available on request, and can be found at www.henrythornton.com.)

There is a tendency to an inverse correlation. That is, the happier the Reserve, the lower the cash rate, and vice versa. But the story is no simple one.

We judge that in 1997 the Reserve was in fact poised between happiness and joy (happiness index reading of +3).

Inflation was low and falling and unemployment was high but edging down. Low inflationary expectations allowed the Reserve to reduce cash rates in the hope, one imagines, of encouraging employment. Gradually inflation began to look less benign, and by late 1999 the Reserve's happiness began to seriously erode. The GST was introduced in mid-2000 and uncertainty was high.

Rate hikes followed in rapid succession until, by 2001, unemployment began to look serious.

Reserve Bank happiness fell to the lowest level yet recorded.

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In 2002 there was a rapid swing from real unhappiness to full-on joy, and interest rates began to rise. Unemployment was falling faster than anyone had imagined possible, inflation was under control and expected to remain so, and all that seemed necessary was the occasional touch on the monetary brakes.

The past year has seen signs of rising inflation and a consequent erosion of the Reserve's happiness. Continued strong job growth has meant that the Reserve has no strong reason not to raise cash rates relatively rapidly, and it is that surprise result for the December quarter that has stayed its hand so far in 2007.

Since the Reserve's board last met, the world economy has performed well. The recent market meltdown produced words of comfort from the great and the good, and the consensus seems to be that we are in for another year of strong global growth, with inflation lower, mainly because many central banks have raised interest rates.

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First published in The Australian and on Henry Thornton's website on March 6, 2007.



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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at www.henrythornton.com.

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