The dash for growth

While the RBA won't change interest rates in February, the drums are beating as capacity constraints emerge. We say the rise in inflation (as well as currency depreciation) is a matter of when, not if, due to Australia’s propensity to run an easy monetary policy. This is the reason we now believe Australia’s monetary policy is in the hands of the market, not the Reserve Bank.

Markets were kinder than they might have been over the holiday season. After the Christmas speculation that the US dollar was all but doomed, in January it bounced. This was a dead cat bounce, but a bounce none the less, and Australian policy makers were able to bask in the sun. Then the December quarter inflation result - slightly above expectations and above the mid-point in the target range - woke markets from their slumber. Skills in short supply in many sectors will inevitably produce additional cost pressures.

The professional pundits and commentators, left to think for themselves over the holiday period, had broken out in discord. Now, many people are beginning to think in a more hawkish way, and the press is beginning to warn of an imminent monetary tightening. Some in the market, and perhaps the Reserve, do still worry about a crumbling in demand. Private bank employees are especially uncritical as their employers curry favour with the government, the seller of the next big bloc of Telstra shares. But most recognise what we have said all along, that the next move is up and ought to have occurred already. It will happen before June.

The Reserve Bank rested on its laurels through 2004, and did not change interest rates. The Reserve’s boosters say this was brilliant management. In the event, the slight tightening in late 2003 certainly slowed the housing market, but little else. Domestic demand did not crumble. Instead aggregate demand remained too strong through the year, the current account deficit blew out to record levels and the housing sector is now showing signs of revival rather than continuing to pull back as the dream script had suggested. There is a straightforward description of Australian monetary policy in 2004 - “The dash for growth”.

Apart from the big imbalances of the current account deficit and overvalued housing, there were other warning signs in 2004 - the worryingly fast pace of growth of non-tradeables prices, the excessive growth in demand for and supply of credit and the tightening in the labour market. All the warning signs are now coming back to haunt the Reserve. Demand has been too high for too long, but now supply (drastically less than demand in any event) has hit capacity constraints. The current account deficit, overvalued house prices and other signs of economic imbalance should have prompted tightening when the global outlook was favourable. Now the outlook is less favourable, with the edge expected to come off the global economy as the US tightens further its monetary policy. The RBA faces choosing between two unhappy scenarios - to tighten in an attempt to regain control of the economy or to leave the job to the market.

Of course, Australia may stay lucky, and markets may be kind. If so, we may muddle through with a few jarring bumps. But the big risk is that the current account deficit expands still further from its present unsustainable levels. The graph shows our guess that the current account deficit is likely to reach 7 per cent of GDP in the current year.

If such a forecast becomes widely accepted, this is likely to make international investors think the Australian dollar, and Australian assets generally, are greatly overvalued. The government would be quite wrong to be looking to Labor’s leadership chaos to determine whether the seas ahead are rough or smooth, or what dangers lie beneath.

There is, however, one event that would validate the “dash for growth” - another burst of serious economic reform. Suppose the government said it would grasp the nettle of radical tax and welfare reform, following the lead of its courageous backbench ginger group (and most economists)? This would have an extraordinary positive effect on the economy and incomes in the long run.

It would be well worth the short-run cost: both Henry Thornton and a responsible central bank would also have to warn that the likely euphoric reaction in capital markets would force an Inflation-Plus-targetting central bank to raise interest rates.

(Technical note: Inflation-Plus is the description of a clever research economist for the Reserve Bank’s current policy regime, as it is leaning to take account not only of goods and services inflation (the formal inflation target) but also asset price inflation, without of course having in mind any absolute levels for asset prices. Inflation-Plus is a way to address concerns about credit growth that too narrow a focus on goods and services inflation-targetting might let slip by. See Stephen Bell, Australian Economic Review, December 2004.)

Might the Bank be brave enough to give advice in support of tax and welfare reform? It intervened in the late 1990s to tell the Treasury to stop selling the A$ when it was panicked into closing its speculative debt-management hedging positions. And it advised Treasurer Keating in the mid-1980s to tighten monetary policy, cut wages and move the budget from deficit to surplus. Now it needs to persuade the government that a higher A$ as a result of a fundamental shift in the terms of trade and a fundamental improvement in the structure of government intervention (lower taxes and less welfare spending) is something that should be welcomed, even if the side effect is that macroeconomic policy will have to be adjusted to achieve an acceptable balance between supply and demand (aka the current account deficit). The policy reform would of course also make financing a larger current account deficit easier, by attracting additional capital inflow as the potential rewards for investment in Australia increased.

Henry will applaud if the government does grasp the stick of radical tax and welfare reform. If the RBA in that circumstance had to further tighten monetary policy, we would acknowledge that it was strong fundamentals driving interest rates higher. In the absence of that next logical step in economic reform, interest rates will be forced higher for the much more traditional reason that aggregate demand exceeds aggregate supply and the outcome will not be pleasant.