Official interest rate policy: could we be wrong?

The key question for the Board and the Governor of the Reserve Bank, as it is for Henry Thornton, is: “Could we be wrong about monetary policy?”  If Henry Thornton is right and policy should have been tighter and has to be tightened again with the horse already bolting, the Board will have presided over the worst year of monetary mismanagement since the late 1980s. If Henry is wrong, he too will be embarrassed, and he will admit this here.

The Board will approve the text for its Annual Report.  More important will be its decision whether to raise cash rates, or leave them unchanged at 5.25 per cent. Leaving rates unchanged is the easy option. Because of antiquated convention, the RBA would have no immediate need to explain its decision. By contrast, if rates are raised, there would need to be an explanatory announcement today of the utmost sensitivity. The economic and political bruhaha would be something to behold.

Which do we think is more likely? Obviously, on the Board’s performance over the past two years, we have to expect there will be no change in the cash rate. The overt coaching from the Prime Minister and the Treasurer, that an increase would be unjustified because inflation is currently in the centre of the RBA’s target range, certainly reinforces the attractiveness of doing nothing.

But which course would be the better for the long-term future of Australia?  Because it takes time to have its effects, monetary policy is supposed to be pre-emptive. With the present weaker Australian dollar, the relentless four per cent pa rise in non-tradeables prices will soon dominate headline inflation figures.  An increase of 0.5 per cent in the cash rate, with a statement that says: “we (the Board) will do whatever it takes to secure Australia’s economic future” would probably do the trick.

Might we be wrong? Our view about the world economy has been similar to Fed Chairman Alan Greenspan’s – global growth is strengthening and growth in the US is self-sustaining. To the extent we have been able to glean the views of the Board from official speeches, it would seem they have come to agree, after a period of doubt based especially on imbalances in the US. 

To be sure, there is still reason for debate over the immediate path for the global economy, while the US works through a patch of comparative weakness and the out-of-control pace of Chinese growth is reined in. Earlier overdramatic fears of a crash, rather than a sensible rebalancing, in the USA and China, ought to be put aside. Now we should all be monitoring the global economy for signs of an inflection point, presaging slower global growth as the authorities in both countries tighten the stance of policy. The process of monetary tightening is underway in many major countries.

It is over the performance and outlook for the domestic economy where the Board and Henry Thornton hold more striking differences.  Our view has been that domestic demand has been growing unsustainably fast and that policy (both fiscal and monetary) has made this worse. Monetary policy has been tightened “too little, too late” and at every stage more ought to have been done.  

We admit that this has been a difficult period for Australian monetary policy. Economists are still highly uncertain about the analysis of asset booms and bubbles – although it is widely agreed such events occur regularly, are credit-driven and mostly have unhappy endings, as we have been saying in this column for two years now.

(Our comments on asset bubbles are here.

Policy has had to be set in an era where the dominant fact of economic life has been the global property and consumer boom that has resulted from financial liberalisation, the full-on entry of China into the global economy, the quelling of global inflation and the technology productivity miracle. The policy response has been made more problematic by the uncertainty associated with the terror attacks in New York, Bali and Madrid and the “fog of war”. To some extent, economic policy has been sidelined while an effective political response emerges.

Globally, low inflation is due, in part, to low inflationary expectations established in the first half of the 1990s. High productivity growth has also been important, allowing strong overall growth without creating inflation. The cost of this has been the global property boom. Credit is cheap and easy to get. The dominant members of society (including members of boards of central banks) enjoy the benefits of real estate booms and so do not include controlling asset prices in the set of things they feel responsible for. Ditto their political masters.

Of course at some time, if asset booms are allowed to run free, inherent self-correcting economic processes take over. Private bankers exercise some restraint, asset prices stop rising and this itself makes many paper millionaires rein in their previously self-sustaining asset trading. Property values begin to fall, and this reduces growth in consumption.  Economic activity slows and jobs growth falls or even goes into reverse. We judge that the RBA did fear this outcome – but the evidence now is against the property crash hypothesis.

The Board may today express surprise over current Australian trends. Credit growth, which it wanted to see slow, continues to clock up new multi-year records (see graph); housing approvals and retail sales, which it also wanted to see slow, have been stronger than expected; and the balance of trade has been in greater deficit than official forecasts imply is appropriate. However, quite why there should be any surprise, when monetary policy remains accommodative and fiscal policy is aggressively stimulative, is a mystery.

Overall, the growth of domestic prices, of household debt and the associated current account deficit remain a big worry. If global growth does slow noticeably from current levels, maintaining an Australian policy stance that makes more probable the continuation of strong import growth will be a decidedly risky option.

The Reserve Bank may see itself as finding a “middle way” that relies for its success on faster reductions in asset prices (and the economic slowdown that will inevitably follow) in Australia than elsewhere.  If this is the game-plan, it is a high-risk path. It presumes that future asset price declines are locked in and no further rate hikes are necessary.

In our view, it would be far better to get monetary policy back to a more neutral position as soon as possible.  If sharp asset deflation eventuates, rates can always be cut again.  But at this stage, such an outcome looks unlikely and continued excessively strong growth in domestic demand looks more probable.

Will the Board raise interest rates today?  Don’t bet on it – the Prime Minister would disapprove.