The 'nirvana' economy

It’s back to work today for the Reserve Bank of Australia (RBA) board. It is an interesting time, even though Henry Thornton can confidently predict that the members of the Board will individually and collectively choose to leave official interest rates unchanged at 5.5 per cent.

The US Fed has just said goodbye to its long-standing chairman Alan Greenspan, and welcomed former Harvard academic Ben Bernanke as its new leader. Global financial markets have been nervous and will remain volatile in the transition.

Later this year the RBA will face a similar transition when its governor Ian Macfarlane retires. We have already conjectured that the next governor will either be ANU-based but world-ranked academic Warwick McKibbin, who is a non-executive member of the RBA board, or long-serving central banker and current executive member of the board, deputy governor Glenn Stevens.

Because Australia’s monetary policy under Macfarlane’s stewardship has caused few hiccups, it would seem that Stevens has home ground advantage. To most observers, including the joy-boys of the markets, he is clear odds-on favourite.

McKibbin by comparison has undermined his appeal in Yes Minister terms by his willingness to criticise government policy. Over the holiday season for instance, he hit on the Government’s feeble efforts to advance the adoption of greenhouse-gas-reducing technologies by noting its refusal to introduce carbon pricing as an incentive. On the other hand, tough times might be made for a man with a proven record of confronting tough problems.

If you are looking for a complete outsider to punt on, there is always ex-deputy secretary of the Treasury and now experienced head of Westpac David Morgan. However, he of course may be quite comfortable staring across at the RBA from the other side of Martin Place. Then there’s Henry himself, a real smoky!

But we do know that if the Reserve Bank were to mess up (which to a politician means if the RBA were to raise interest rates and the politicians get the blame from an angry electorate), the ascent of Glenn Stevens would not be assured. Macfarlane’s contribution to Stevens’ accession will be not to rock the boat, and if possible to keep interest rates unchanged for the rest of his term.

Macfarlane will hope that the resource boom continues, and boosts exports; that domestic demand remains subdued and restrains imports; and that “core inflation” remains clearly within the target band of 2 to 3 per cent. If this is the case, there is a good chance that interest rates can be left unchanged.

Despite its “nirvana economy” status, Australia faces two demonstrable challenges: a current account deficit (CAD) that is simply not sustainable. And incipient inflationary pressure whose strength is measured by extraordinary demand for various types of skilled labor - especially those whose skills fit the resource sector; upward drift in overall wages growth; and non-tradable goods inflation running at around 3.5 per cent, also not sustainable once the resource bubble bursts or deflates.

What could go wrong? There are global risks and local risks, but they mostly relate to excess wages growth and its corollary, an even more uncompetitive economy. The good news on the global front is that economic activity virtually everywhere outside the US is improving. Global growth seems set for another strong year.

Indeed, with China and India booming, the US still growing strongly, clear signs of recovery in Japan and an improved outlook in Europe, there is some risk that global demand may grow even faster in 2006 than in 2004 and 2005. Such an outcome would put even greater pressure on commodity prices, whose extraordinary strength is already driving a resources boom of considerable proportion in Australia.

This might seem a good problem to have, but it would raise the still contained but increasing risk of a wages break-out in Australia to a point where even Ian Macfarlane might think he had to do something to restrain it.