Bubble, bubble, toil and trouble - interest rates moving up

He has consistently encouraged a dash for growth in this way, and so we have seen a long period of interest rates below neutral - in short, an easy monetary policy. The only problem is that excessive periods of easy monetary policy - interest rates "below neutral" - have to be brought to a close with periods of tight monetary policy - rates "above neutral" - once capacity constraints have been hit.

In an earlier article, in June 2002, we introduced a "Taylor Rule" as one way of defining the appropriate setting of monetary policy. Our forward-looking Taylor Rule for Australia was: The cash rate = the inflation rate + the real interest rate + 0.5*(target unemployment - forecast unemployment) + 0.5* (target inflation - forecast inflation).

The witch's brew in front of the RBA board is a cauldron comprising - at the bottom - an equilibrium real interest rate of 3.25 per cent and an actual inflation rate of 2.6 per cent, implying a neutral rate of 5.85 per cent. If forward inflation were used - a touch over 3 per cent given that "risks are on the upside" - the neutral rate becomes 6.25 per cent or a little more. But add to that gruel some gruesome seasoning: the continuing excess of domestic demand over potential supply of 1 per cent over the next year and - worse still - an excess of inflation over the mid-point of the target of 1 per cent.

A Taylor Rule would be recommending an interest rate 1 per cent higher than mere neutral. In other words, somewhere between 6.85 per cent and 7.5 per cent is entirely plausible in policy-making terms. Let's stir this steaming pot. Unless the board were to disregard the future, the spell to be cast involves moving rates up toward 7 per cent.

Contrast this with Monday's rate of 5.25 per cent and one can only conclude that the decision to raise rates by 0.25 per cent is only the first of several such increases. Domestic demand in the Australian economy might of course slow to an acceptable extent well before cash rates reach 7 per cent.

Indeed, Howard and the rest of the "no hike" school must believe the pressures on inflation will dissolve without policy action.

The highly geared position of Australian households is manifest reason for caution in tightening monetary policy. But in recognising the need for caution, we urge members of the "no hike" school to ask what happens if they are wrong. If demand keeps growing in the absence of rate hikes, and wages and inflation break out, there will be a painful slowdown imposed by far higher market rates at some stage. Far better to try to get ahead of the game and therefore, possibly, to head off this damaging scenario.