Unbalanced economy a challenge for the RBA

Recent hints by the US Fed that it will at some stage begin to normalise monetary policy have produced sharp falls in share prices and costly increases in bond yields.

Better economic news in the US and Japan has been one effect of massive monetary expansion, but the financial carnage when this policy is reversed is likely to be great. Having Australia's cost base so out of line when there is sure to be a difficult transition to a more normal global monetary policy is the second barrel of our current double-barrelled disequilibrium.

Australia's monetary policy has so far avoided unsustainable cuts to near-zero interest rates, although the new record low in cash rates of 2.75 per cent is a move towards the inflationist position.

Despite recent falls in commodity prices, which previously would have caused the Australian dollar to fall more or less in parallel, global investors seeking yield have been pouring money into the country. The net result is a high dollar that is making Australian industry uncompetitive.

The RBA has in times past been tempted to cut interest rates when there was what was perceived as undue pressure on the currency, such as in the recovery from the mild recession of the mid-80s. In particular, in the late 1980s rates were eased inappropriately and the result was an eventual sharp tightening of monetary policy and the severe "recession we had to have".

Orthodox economists say the first response to our current, greatly distorted position should involve cutting interest rates. My hard question for the Reserve Bank is this: would you be willing to take Australian cash rates to zero, the only rate at which Australian yields would equate US yields, and therefore remove the excessive capital inflow -- seeking yield -- that has been driving our dollar far higher than is desirable?

Regular readers will be aware that I have been urging the Reserve Bank to keep monetary policy firm and to manage the dollar down by controls over excess capital inflow.

This is an unorthodox policy proposal, but safer than embracing the dangerous path to a highly inflationary monetary policy.

Competitiveness will only be restored by a fall in costs measured in foreign currencies, and this will only be achieved after a large devaluation if domestic costs are seriously restrained.

Such an outcome usually requires tough, usually very tough, monetary and fiscal policies. Minimising the cost in terms of lost jobs requires unions and non-unionised workers alike to accept lower wage hikes and governments to provide smaller welfare increases than the inflation which will be a consequence of the currency depreciation.

In an age of entrenched entitlement it is hard to see this happening.

Far better to head off the reduction of competitiveness in the first place by maintaining firm domestic policies, buttressed by controls over capital inflows to prevent a rising exchange rate eroding competitiveness.