Reserve Bank should think for itself as inflation threat looms

The Reserve Bank of Australia is expected to cut interest rates again today, perhaps by as much as 100 basis points.

Keynes famously said there were conditions in which easing monetary policy was like "pushing on a string".

We know that tightening monetary policy can slow or stop the economy and therefore, eventually, slow or stop inflation. We know that inflation is an insidious cancer that destroys economies. Yet the destruction takes time and its effects are usually not noticed until it is too late to stop inflation without severely damaging economic activity.

Having allowed the global economy to overheat, and thus generate inflation, including severe asset inflation and boomtime commodity inflation, central banks applied the brakes just as the asset and commodity bubbles were beginning to correct themselves.

Easy money in the early years of this century fuelled inflation, and monetary tightening was too little, too late.

In fact, delayed tightening usually means rates rise further than they needed to, as happened in Australia. Markets overshoot, and so do central bankers.

The Reserve Bank of Australia was not the worst offender - the Zimbabwean authorities deserve that dubious distinction, and among serious nations, the Federal Reserve Board of the US stands out.

But the Reserve Bank went along with the generally accepted doctrine of gradualism in tightening monetary policy.

There was another mistaken doctrine among central banks. The idea of "inflation" targeting was, and remains, sound. But goods and services inflation of relevance to consumers was too narrow a target. For the past decade, this measure was artificially held down by the emergence of China and India as leading industrial and trading nations.

So central banks responded too slowly to a misleading indicator.

This perhaps demonstrates that central banks may be given "independence" from political government. But independence from the group-think of the golden legion of central bankers is harder to achieve.

The point of recapping the recent history of central banking is to make a plea for more independent thinking in battling current economic problems.

So far, Henry has applauded the Reserve's brisk reduction of cash rates. This is best interpreted as learning from the mistake of raising rates too slowly in the boom.

Since equity prices and commodity prices have also been falling, the RBA may also be taking account of a wider range of indicators of inflation. Their successive reports indicate as much. But the fact of all central banks cutting rates much faster than usual suggests that there is a fair amount of group-think at play here. If they bothered to comment, central bankers would deny this, preferring the label "global co-ordination".

All 18 economists surveyed by AAP last week expect the Reserve Bank to cut interest rates today. Eleven expect the cash rate to be slashed by 75 basis points, while five of the economists polled are tipping an even larger 100 basis point rate cut.

These forecasts show commendable adaptation to the faster-than-usual policy action, which itself shows a commendable response to past policy mistakes.

The key point to recall, however, is this: the Australian economy is in far better shape than those of just about all other countries.

The US news is still mostly pretty dismal, though Wall Street had a nice bounce last week.

An optimist might conclude that market participants are at the point where they think the worst of the news flow is in the market.

A pessimist is an optimist with experience.

President-elect Barack Obama has made the economy his immediate priority and has announced a stellar economic team, including Larry Summers, Tim Geithner and - the big surprise - inflation fighter Paul Volcker.

The US economy is still the most flexible around, and adjustment will be fast. There have been massive bank bailouts piled on fiscal stimulus, with more stimulus expected from the incoming president. US fiscal stimulus will create massive budget deficits and unprecedented mountains of debt, which future generations will need to service or repay. US cash rates are at 1 per cent and the Fed may have at least one more cut in its locker - some want zero.

Beyond zero there is the new concept of "quantitative easing", which is defined as the Fed exchanging private paper for Fed paper.

If pushing on a string fails, exchanging private for official paper seems to be the new monetary doctrine. How this can fail to ignite inflation is yet to be explained, but no doubt this will be tested in the laboratory that is the US economy.

Euroland shares followed Wall Street's positive lead last week, but so far it has seen the smallest interest rate cuts and relatively small fiscal stimulus.

Conservative sluggishness is the heritage of hyperinflation in the old world.

China is set to slow, and the People's Bank of China has cut cash rates aggressively, most recently last week by 1.08 per cent. Political leaders naturally fear the unrest if millions of newly industrialised workers lose their jobs and substantial fiscal expansion is also on their agenda.

Globally, the financial system is still fragile, with freezing of redemptions by fund managers (including hedge funds and private equity funds) the next predictable crisis point.

Retirees everywhere are facing substantial loss of wealth due to equity market weakness, but freezing redemptions will produce further trauma.

Surely not even the Obama team will find it possible to bail out hedge funds and other managed funds?

Relative to the major economic zones, the Australian economy looks relatively strong, although our banks and markets have been fully integrated into the global financial firestorm. Business investment is still expected to rise strongly, and credit growth has slowed, but far from catastrophically. Business and household confidence is low (though with some recent recovery) and there are substantial job losses in some sectors, despite official statistics apparently holding up.

Governments are increasing spending and the federal authorities are laying the basis for a possible "temporary deficit". Inflation is far too high, at 5 per cent, although inflationary expectations have fallen sharply. Temporarily at least, inflation has been put in the box marked "she'll be right, mate". But this cannot be the case forever, of course.

Sometime soon the Reserve Bank will again focus on its core task. It is to ensure that inflation is eliminated.

While there are credible fears of the economy slipping into recession, sharp rate cutting will be the name of the game.

Henry will not be surprised if there is a 100 basis point rate cut today. If the cut is only 50 basis points, this would be good news. It would signal that the Reserve thinks the economy is not sliding into recession, and it is again getting back to its main task.