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Caution is the better option

By invitation, I wrote the following Op-Ed article for publication in one of the dailies tomorrow morning. I had 500 words so couldn’t say much. The good thing about today is how wrong the market economists were. The bookies even closed the book because they claimed it was a 100 per cent probability that the RBA would put up rates. Anyway, they didn’t which is good but they will which is bad.

Contrary to the expectations of the financial markets, the Reserve Bank of Australia (RBA) held its policy interest rate constant today at 3.75 per cent. This was always a likely option given the fragile state of the economy and the need to foster private investment spending.

The financial markets were wrong again. Given that the recent financial crisis was engendered by the poor judgement of market participants, one wonders why they still have the credibility that the media ascribes to them.

After noting that the recovery in the major economies is likely to be modest over the next two years, the RBA statement said that “inflation is expected to be consistent with the target in 2010”.

Monetary policy is conducted principally by the RBA manipulating the short-term interest rate upon which all other rates (mortgages, etc) are based. Its aims to keep inflation within a 2 to 3 per cent band by moderating aggregate spending.

The RBA increased rates three times in late 2009 which moved its target rate towards its so-called neutral range – where policy is neither expansionary nor contractionary – somewhere between 5 and 6 per cent.

That assessment is not uncontroversial and I have criticised the RBA for keeping rates too high prior to the crisis given the record debt levels being carried by households.

Today’s decision reflects the fact that the major banks pushed their lending rates up proportionately more than the official rise in late 2009. This has led the RBA to reconsider its assessment of its neutral policy range.

In December, the RBA indicated that its neutral rate was probably much lower than previously thought and at 3.75 per cent was likely to be in the neutral range (albeit at the expansionary end).

Today they noted that the impacts of these excessive commercial bank rate increases were still unclear and so it was “appropriate to hold a steady setting of monetary policy for the time being”.

I consider the decision to be sound. With economic growth still subdued and labour underutilisation rates high there is plenty of excess productive capacity and thus no danger of an inflation breakout in the foreseeable future.

The last thing we need is for monetary and fiscal policy to be working against each other which might jeopardise the modest recovery we are now witnessing. The fiscal policy stimulus is waning now and so continued growth will be reliant on strengthening private investment.

Recent data covering job advertisements and business confidence is still pointing to a very fragile economy.

What about the future? The RBA signalled that if growth continues as expected then monetary policy “will, over time, need to be adjusted further in order to ensure that inflation remains consistent with the target over the medium term”.

But with the excessive commercial bank rate hikes, I don’t foresee a return to 5 or 6 per cent interest rate this year. Some modest rises in the coming months will be likely though.

This Post Has 9 Comments

  1. I was very happy when I read the RBA wouldn’t be raising rates even though it would have been good for me since I don’t have a mortgage.

    I bet all the big papers and news sites had mountains of ‘analysis’ ready for print which all turned out to be worthless. even seemed to think Tony Abbot’s ETS or whatever it is he is proposing (I didn’t read it) was more newsworthy by placing it higher up on the page. This all appears very embarrassing for our local stock of ‘expert’ pundits and commentators.

  2. Dear Bill,

    How does MMT explain inflation in our economies when they clearly are not, nor have they been, operating anywhere near fullemployment in the past. Under MMT, Inflation seems to only be a of concern when the economy is at its full capacity with full output and full employment. This has clearly not been the case in the past. Yet inflation, even if at single digit levels, has indeed occured…

    I would greatly appreciate a somewhat more sophisticated insight into the dynamics of this.

    Thank you in advance for your efforts.

    Kind Regards

  3. “How does MMT explain inflation in our economies when they clearly are not, nor have they been, operating anywhere near fullemployment in the past”

    We had near full employment for around 30 straight years from WW2 to around 1975.

  4. John, two examples.

    First, a supply shock in a sector that affects the entire economy, such as energy, can result in “cost-push.” When the OPEC cartel jacked up petroleum costs, the result was a general price rise as production cost increased. Other countries had no control over this (although some argue that it was in response to the US reneging on dollar-gold convertibility). Such shocks are considered exogenous.

    Second, the commercial banking system controls the money supply through the creation of bank money or credit money (lending creates deposits). Banks can extend excessive credit relative to real output capacity, which then drives up prices across the board through “demand-pull.” This is, of course, endogenous. The Fed has different tools for addressing this, such as interest rates and reserve requirements, which can be employed to increase the cost of credit and dampen demand for it. Bank leverage requirements can also be increased.

  5. John,

    as far as I know prices for computers and related stuff have been falling ever and forever.

    It depends on what you measure and how. If you think agriculture then it is one of the most regulated areas in any economy. If you think oil then it is external. If you think housing then somebody forgot to regulate lending properly.

    Inflation is the creation of the system by which ever increasing share of GDP goes to capital rather then workers. And since there rarely are salary cuts you can safely assume it is all about margins. Do you think they have effect on prices? People used to buy what they needed. Today people want to consume products because there is hype, social stigma or whatever. It gives producers much more pricing power. Then you can consider ever increasing concentration in virtually every area due to mergers, etc.

    One can find many arguments why prices increase. However the main point is that government gives companies power to do that

  6. The interest rate is a completely useless exogenously determined variable that tells us bugger all about the state of the economy.

    The so called experts love to report RBA announcements not because they are meaningful but because it boosts their profile amoung the general public.

    Something for the kiddies to aspire to:

    “Oh Look Ma its the Chief Economist from Plummet Banking!!!!”

    Well Johnny if you read one book on economics, ignore the facts and base all your assumptions on your own idelogical predjudices then I’m sure you too could one day be a useless bag of #### on the TV as well.

  7. With regard to the mortgage rate rises, it is interesting to note that Westpac’s mortgage wrote 42% of the mortgage business in December despite raising their mortgage rate by more than the other banks in December and the banana smoothie debacle. Since the rest of their loan book (corporate lending, business lending and credit cards) would not be growing that fast and bank wholesale borrowing rates are still very high, you can be sure that the bank is actually not too happy about how much business they are writing. That would help explain their recent tighten of loan-to-value (LVR) requirements. Even if the RBA doesn’t raise rates again soon (and like everyone else I expect they will), do expect to see banks narrowing the gap between the mortgage rate and the RBA cash rate any time soon.

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