Global monetary policy tightens

Recent economic news strengthens the case that the next move in rates is far more likely to be up than down.

But the big question for Australian economic policy remains as it has been for some time. When will the Treasurer grasp the nettle of serious tax reform?

US Fed Chief Ben Bernanke produced no suprises following the recent meeting of the Fed’s policy-making committee. Cash rates rose to 4.75 per cent and the language changed few if any minds about the prospect of at least one more increase. Indeed, it seems that the words were slightly more aggressive than the average expectation, and this produced a stronger US dollar, higher bond yields and a mild reduction in US equity prices.

Record low US cash rates have now been corrected, and the gap with Australian cash rates has narrowed dramatically - see graph. One consequence is that the Australian dollar has taken a dive from the high 70s to the low 70s. No drama yet, but this is an important indicator, a modern monetary equivalent of a canary down a mine. And this canary is looking a bit wobbly on his perch.

This mild negative surprise from the US Fed was not mirrored elsewhere. Asian and European shares continued their recent rises. The prices of oil, gold, other precious metals and copper rose further. The flow of stories about the latest round of iron ore price negotiations became more positive and it seems China’s rulers have abandoned their rumoured attempt at old-time price control in this area. Nuclear power is suddenly being looked at less negatively, and Australia has about 40 per cent of the world’s known deposits of uranium. Resource stocks reached new highs.

In the United States, it was weaker than expected housing data that led some on Wall Street wrongly to predict softer Open Market Committee rhetoric. Overall, however, US data has continued to indicate economic strength. China is growing strongly, while in Japan and Europe recovery is strengthening. The overall prospect is for continued exceptional strength in global growth.

Risks remain - the Middle East is in a ferment, bird flu continues to worry many people and some economists believe US housing will induce a slowdown there. But for the present one can say monetary policy should not be used in attempts to offset problems that may never eventuate. The prospect is therefore for increases in global interest rates, with almost all central banks tightening, or thinking about tightening.

In Australia, ABS job vacancies rose by 4.7 per cent in the February quarter, just shy of the record highs reached in early 2005, and this bodes well for employment in the rest of 2006.

Retail sales for February also surprised on the upside, rising 0.7 per cent in February compared with predictions of 0.3 per cent and a strong (revised) 0.9 per cent per cent in January.

Aggregate credit growth also seems to be rising again. Credit growth probably bottomed at around 13 per cent per annum in early 2005 and has risen to 14 per cent in the year to February 2006, led up by lending to business, running at 16.5 per cent per annum.

Total credit growth of 14 per cent is rapid in an economy growing at a nominal 5-7 per cent per annum pace, and is one factor leading analysts to revise up their forecasts for Australian GDP growth in 2006 and 2007.

Profits are high, skilled labor is scarce, fixed capital spending is expanding strongly and aggregate demand is being supported by the strong terms of trade. Growth in business demand for credit is more likely to increase than to slow from here.

In short, the Australian economy is again picking momentum with growth likely to be above trend in 2006. With the mother of all resource booms and the recent sell-off of the Aussie dollar, the big issue for the second half of 2006 is likely to be overheating and, dare we whisper, inflation. And we advise, following Basil Faulty: "Don't mention the CAD!"

The budget is in surplus, and pressure is building on Treasurer Peter Costello to start the hard grind of another round of tax reform. So far he is resisting this pressure manfully, and one can only admire his fortitude as virtually every galah in the pet-shop, including Henry, believes he should give in gracefully. One recognises, of course that the Treasurer wishes to avoid adding fuel to an already buoyant economy which the latest data says is already picking up speed.

The answer here is to announce some goalposts for real tax reform, including a 30 per cent top marginal rate of income tax and the number of years in which it will responsibly be achieved - such as 5 to 8 years. Simple arithmetic suggests that the annual reduction in the top rate should be manageable in a buoyant economy.

Suppose for a moment the Treasurer does as most economists believe he should and grasps the nettle of serious tax reform.

The knee-jerk reaction of some to such a graduated, pre-announced program of tax cuts might be to say interest rates would be higher. Of course the net effect on aggregate demand in the economy would depend on other budgetary changes and the Reserve Bank would hope those other changes made the overall reform package approximately neutral in its effect on aggregate demand. But there is a far more profound issue to consider. The effect on the supply side of the economy would be to encourage work, household saving and entrepreneurial effort.

In Henry’s judgment, these favourable supply side effects might well outweigh the effect of tax cuts in raising aggregate demand even if the effect of the tax cuts on demand were not offset by other budgetary changes. But the main point is that a gradual, pre-arranged program would allow plenty of time and expertise to be brought to bear to ensure the overall economy remained in balance. Perhaps monetary policy would need to be a touch tighter, but there is no way there would need to be a dramatic tightening of monetary policy to “undo” the effects of cuts to income tax.

Whether (or when) cash rates again begin to rise in 2006 lies in the lap of the gods. As we have said for some time, RBA Governor Ian Macfarlane will do everything he can to sit on his hands at least until his choice of successor is signed on for the traditional seven-year term. Recent economic news, however, strengthens the case that the next move in rates is far more likely to be up than down.

But the big question for Australian economic policy remains as it has been for some time. When will the Treasurer grasp the nettle of serious tax reform?