The RBA's self-destructive policies

Australia's central bank raised its benchmark interest rate a quarter percentage point on concern over wage inflation. Talk about a hawkish central bank, even in the face of a slowing economy Governor Ian Macfarlane sees inflation as a much greater concern than pumping up growth by a few more percentage points. Higher rates are needed "to reduce the risk of an unacceptable rise in inflation," Macfarlane said. Annual inflation may reach 3 per cent by the end of 2006, which is the top of the bank's target range, or even exceed that, he said.

This is why we like this central bank; they know that by keeping inflation at bay their currency will remain strong and their economy will stay on a slow but steady growth track. While the latest GDP figures reflect a slowing economy, Governor Macfarlane said the figures are “understating” the strength of the economy. "Although Australia's GDP slowed during 2004, this does not appear to have reflected any deficiency in domestic or global demand", he said. "The Australian economy is now in the 14th year of an expansion, which has made substantial inroads into the economy's surplus productive capacity.

The Daily Pfennig, March 4, 2005

The deeply disturbing feature of this comment is that two highly professional and responsible people - a central bank and a distinguished analyst - show so little understanding of the basics of economic and financial management.

The crucial feature is that both assume that a rise in interest rates will eliminate "the risk of an unacceptable rise in inflation". This is after more than 30 years of evidence that a rise in interest rates does not moderate inflation. On the contrary, a rise in interest rates intensifies inflation or the risk of inflation.

We have had more than 30 years in which the Australian central bank - and other central banks - have raised interest rates to "fight inflation" and the result has been a reduction in supply, while demand has been maintained or reduced less than the reduction in supply.

In the earlier years of these misconceived policies, we got “stagflation” - more unemployment with more inflation. As governments and central banks persisted with such policies, inflation shifted from domestic price increases to deficits in the balance of trade and payments. What does the Australian Reserve Bank expect from the hike in interest rates it has just imposed? What does it expect from the further hikes in interest rates that might be likely in the months ahead?

Let's be clear that an increase in interest rates will have a moderating impact on asset-price inflation. The evidence over the past 35 years is clear that a hike in interest rates will hit, and if sufficient, will kill such phenomena as a housing “bubble” or a stock-exchange “bubble”. Just how brutal the impact will be will depend on how long the “bubble” has been allowed to swell and what other action may have been possible and may have been - or not been - taken to moderate it.

However, we must be very clear that a hike in general interest rates - a hike that applies across the whole credit spectrum - is just about as blunt an instrument of economic and financial management as our treasury and central-bank boffins can devise. Like a bushfire out of control, it can destroy everything in its path. It can moderate a housing boom and even burst the bubble with a severity that can cause acute distress both to the big-time developer and speculator and to the small own-home-buyer. But the impact won't stop there. All businesses that depend on credit - manufacturers and miners, farmers and retailers, IT service providers and educators - will see their costs go up.

Those operating on small margins might find that their enterprises are no longer viable. They will go out of business. Their factories will close. Their farms will go up for auction. Jobs will be lost. Unemployment will grow - and welfare payments will increase while tax revenues decline.

There's nothing mysterious about this. We've been through the process many times. Central banks certainly know what will happen. Why then do they do it? The Daily Pfennig says, "This is why we like this central bank; they know that by keeping inflation at bay their currency will remain strong and their economy will stay on a slow but steady growth track".

Is there any truth in this? Is there any truth in what the empirical evidence suggests is a complete myth? For Australia, the devastation of the currency - the Australian dollar - started way back in the early 1970s. In December 1972, the Whitlam Government appreciated the Australian dollar by some 7 per cent. Since then, the road has been almost constantly downhill.