Rate hikes can avert crisis

We can recall no other time in Australia's post-war history when the economic outlook has changed so quickly. The change is generated by belated recognition of domestic imbalances.

It does not concern the international outlook - the twin engines of global growth, the US and China, are performing strongly.

The price of oil is high and has again set a new record, at least in nominal terms. But when adjusted for inflation, oil is still cheap and the expectation of higher prices seems widely shared and not especially worrying.

Australia is an energy exporter and probably benefits in net terms from high oil prices. Coal prices have almost doubled and Australia's uranium is worth a lot of money in a world increasingly concerned about global warming. Australia's terms of trade have not recently been higher and this is keeping the prospects bright for farmers and miners.

Australia's foreign debt is also at a record level, and yet there is a silver lining as global interest rates are still low, although the inevitable increases are well under way.

The current account deficit is about 7 per cent of GDP, the one sign, obvious for at least a year, that domestic demand has run too far ahead of the capacity of the domestic economy. The supply-demand imbalance is also likely to create serious inflationary pressures. The Reserve Bank has said inflation might rise to the upper end of the 2 to 3 per cent target range, or even higher. The RBA has not revealed the assumptions behind this prediction, but our calculations suggest it assumes the Australian dollar at current levels, only slightly faster wages growth and slightly lower productivity growth.

A serious wages surge, say to an annual rate of 5 per cent, is possible. Zero or even negative productivity growth is also within the range of the possible, as is a fall in the value of the Australian dollar to US70c - or even lower.

These less favourable outcomes would mean inflation above 4 per cent, perhaps above 5 per cent. This sort of deterioration is by no means assured, although if domestic demand continues to run at a substantially faster rate than domestic supply it will become almost certain.

We must point out that the thrust of our advice in these articles for some time now has been to head off exactly this scenario. Our advice to this effect has sadly not been followed and the RBA must now deal with a clear demand-supply imbalance that even blind Freddy could notice. The RBA board's discussion today will be of particular interest.

The secretary of the Treasury, Ken Henry, will emphasise the risk that domestic demand falls away without any further tightening of monetary policy. He will promise a tough federal budget next month and he will warn of the risk of a double-whammy hit to a weakening economy.

He might throw in an optimistic assessment of the chances of serious labour market deregulation once the Government controls the numbers in the senate. The members from the private sector may be sympathetic to this line of argument. Those with a great interest in the state of retail trade and rents in shopping centres will probably point out that consumer confidence has fallen and sales are sluggish.

Exporters will note that Australia's sluggish exports are a major problem, that the currency is too high to allow Australia to export more and that higher interest rates will worsen competitiveness by driving the currency higher.

Those arguing for caution will say that housing is delicately balanced and that higher rates of interest could create serious downward momentum. A major fall in house prices would further weaken consumer confidence and retail buying power.

Business members of the board will observe, to varying degrees, that Australia has failed to invest in necessary infrastructure, there has been insufficient investment in skills, education and training, social welfare is too generous and the multiple layers of government are imposing an onerous burden on business.

One or two may even complain about the burden of taxation and ask in some exasperation why something cannot be done. If someone is feeling especially irritated he (or she) might well ask why this situation has been allowed to develop.

The secretary of the Treasury is likely, at this time, to say Canberra is well aware of all this, but no-one in this room should fool themselves - tighter monetary policy cannot make up for deficiencies in other areas of policy. He may even warn that a recession is likely to seriously reduce the chances of effective reform in the broader arena.

The governor and deputy governor of the RBA (probably supported by Warwick McKibbin) are likely to weigh the risks of an inflationary break out far more highly than Treasury or private business interests. They will almost certainly have approved papers for the board that emphasise this risk and which conclude by recommending another rate rise followed by a period of stability while economic developments are monitored closely.

The relevant monitoring will include assessment of the May federal budget and of the plans for wide-ranging reform of labour markets, improving education and training, reducing business regulation and fixing commonwealth-state relations.

If they are on song, they will point out that all the things that might allow an easier monetary policy than they are advocating - such as a seriously responsible budget - are hypothetical or in the case of serious economic reform, are even more uncertain or at best will take a long time.

The governor should sum up the debate by saying: "What we know now is that monetary policy needs to temporarily reduce overall demand to maintain stability until other policies act to improve the supply side of the Australian economy." If there is no rate rise announced tomorrow you will know that the RBA governor has been rolled. You can also factor in a distinctly greater chance - at least 50 per cent - of an old-fashioned crisis later in the year as the Australian dollar dives and inflation climbs. Even with a rate hike tomorrow, at least two further 25 basis point increases will be needed, although there may well be a pause to allow clear water for the federal budget.