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Reserve Bank should sit tight on interest rates

By Henry Thornton - posted Tuesday, 6 July 2010

Global uncertainty has seen falling share prices beyond normal "correction". Cooling domestic house markets have been reinforced by weak retail sales and other indications of caution by households, though jobs growth remains solid. Without too much controversy or hand-wringing, the Reserve Bank board should resolve to keep monetary policy unchanged today.

The next big test for domestic monetary policy comes later this month with the release of data on consumer price inflation for the June quarter. There have been many signs of domestic inflation and if these are confirmed later this month, the Reserve will be on the horns of a sharp dilemma, especially if asset inflation is flat or still falling and if global uncertainties continue.

Commentators who call for rate cuts, or market participants betting on lower interest rates, may be disappointed. But it is easier for a Labor government to sack its leader and prime minister than for the Reserve Bank to turn on a dime after a deliberate campaign to get rates back to neutral from a position of "emergency" ease.


Objective factors behind international uncertainties are: Europe's sovereign debt crisis, with its risk of banking debt crisis; China's housing and goods and services inflation and attempts to rein them in, which have raised fears of serious slowing in the world's locomotive economy; and continued weakness of the US economy, which still wallows with 15 million unemployed workers.

Less objective but equally important are differences of view on the role of continued fiscal stimulus in the major economies as set against the need to cut what are enormous budget deficits to limit growth of sovereign debt. The G20 met recently and did its best to paper over the differences.

When leaders squabble over the fundamentals of economic policy, business confidence cannot help but be damaged. When business confidence is damaged, at least some employees of business, that is, householders, will take defensive action. A downward spiral of poor confidence leading to depressed conditions and further falls in confidence is the clear risk.

There was the Long Depression (following the panic of 1873), then the Great Depression (of the 1930s), and now we are in the early stages of a third depression. "This one is primarily a failure of policy," says a global guru.

Nobel Prize winning economist Paul Krugman recently issued a strident alarm: "In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and the European Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today's governments allowed deficits to rise. And better policies helped the world avoid complete collapse: the recession brought on by the financial crisis arguably ended last summer." The failure of policy is "obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending". Krugman bemoans the fact that "over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy".

The fact is that monetary policy is still very easy in the US and Europe, and this ease has promoted the substantial uplift in equity prices that has now been so decisively interrupted.


The need for years of fiscal austerity, if debt levels are to be contained to manageable levels, will make inflation seem like the least costly way to relieve debt. The world may repeat on a global stage the mistakes of individual nations that have allowed their economies to spin out of control when debt levels become unmanageable.

Despite Krugman's assertions, concerns about inflation are not a recent development. Before the global financial gridlock in September-October of 2008, there was much concern about inflation. This writer's hypothesis is that a major surge of inflation was interrupted by the financial turmoil of late 2008. As the turmoil subsides, inflation will re-emerge as a serious and intractable problem, quite possibly combined with weak or even stagnant activity in major economies, including the US and Europe.

Australia has experienced a recent flood of less positive data. Most dramatic, perhaps, is evidence of a sudden cooling in real estate markets. If confirmed in the form of slowing or falling house price inflation this will be recognised as a major win for the Reserve. Retail sales have been sluggish, and this is another win for the Reserve. Like other developed nations, Australians need to save more and consume less. Real tax reform, including an increased rate of GST, would take weight off monetary policy, but this assistance is unlikely from either political party with their current leaders and stated policies.

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First published in The Australian on July 6, 2010.

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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

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