The RBA`s struggle about what to do

The RBA meets tomorrow facing three objectives. Its single instrument of 'vary cash rate' will not be able to help fix the three economic problems except by accident for short periods.

The RBA has said it is watching the hot property market and some (killjoys) say higher interest rates would help to prevent a boom turning into the next bubble.

The RBA has also shed some crocodile tears about the exchange rate, and sort of let it be known that it welcomed the fall in rates that followed its rate cuts. Lately, however, the currency has rebounded with better global economic news and the lack of the US Fed's foreshadowed 'taper'.

In its real job of containing inflation and maintaining economic activity many advisors (owners of shopping centres, real estate agents) say more rate cuts may be helpful, even necessary.

The RBA is facing three economic problems, some call this a 'Trilemma', and risks doing less than well on all three fronts. (More here, comrades.)

'Monetary policy cannot serve two masters', nor can it handle three. It would be a mistake to reduce interest rates further, even if this would help to reduce, or stop further rebound of, the Aussie dollar.

While this logic seems clear, cutting rates further would presumably make the housing market even more buoyant. Messrs Abbott and Hockey have pointed out that a stronger housing market has many beneficial side effects, so the RBA can garner some brownie points from the new government by cutting rates further and boosting both economic activity and housing sales and also removing upward pressure on the aussie dollar.

'Trilemma, what trilemma?' may be the conclusion of tomorrow's meeting of the board.

But what is to be done if the Australian dollar refuses to fall to 75 cents in the US dollar, a level that would start to restore competitiveness to the non-mining parts of the Australian economy?

It is early days in the recovery of the housing markets so this factor can perhaps be put aside for the moment. However, when monetary policy is too easy and a subdued economy keeps goods inflation low, excess money goes into asset prices, and we are seeing the first effects of this in the housing markets. (Strong global asset inflation has of course been raising Australian share prices for some time.)

The stubbornly strong Australian dollar is another matter, and indeed it is partly driven by wealthy overseas buyers of Australian assets, including Agri- and Mining Companies as well as high end houses.

In the end, the Aussie dollar will only be tamed by Banana Republic #2 (unlikely with this government) or some sort of tax on capital inflows.

While there is no immediate need to slow the housing recovery, in the end the housing market will only be controlled by some regulatory changes to contain the freedom of financial institutions to lend, or by some great big new tax (gasp!) on financial transactions.

The Australian economy is in a very interesting place, and one hopes the RBA fully understands the problems it faces and is communicating effectively with the Treasurer.

However, its failure to deal effectively with illegal dealings in plastic banknotes with the late unlamented Saddam Hussein makes one wonder at its ability to handle more than one important matter at a time.

'We know how to push (or pull) the interest rate lever, Treasurer, but don't expect much else from us' may be the cry. If so, will a presumably demoralised Treasury Chief raise the matter of asset inflation at the meeting of the RBA board tomorrow, and with the Treasurer at the next opportunity?