I am in the final stages of moving office and it has been a time…
This time last month I was trying out the mobile office concept up the coast (see blog). The experiment was a success but the blog I wrote that day coincided with the decision of the Reserve Bank (RBA) to hike short-term interest rates again, which I considered to be a mistake. Exactly, one month later, the RBA is at it again however I am in Newcastle and there is no surf! The RBA announced today, quite predictably, that the policy rate will rise by 0.25 per cent which will push mortgage rates above 7 per cent. Our greedy private banks get another free ride out of this and the decision confirms that the crisis has not really changed the neo-liberal economic policy dominance. Inflation targeting which uses labour underutilisation as a policy weapon and fiscal surpluses which further drag the economy down – are well and truly entrenched. Spare the thought.
In the statement from the RBA Governor we read that:
The global economy is growing … [but growth] … is still hesitant in the major countries … [with] … ongoing excess capacity. In Asia, where financial sectors are not impaired, growth has continued to be quite strong, contributing to pressure on prices for raw materials …
Australia’s terms of trade are rising … [and] … output growth over the year ahead is likely to exceed that seen last year, even though the effects of earlier expansionary policy measures will be diminishing. The rate of unemployment appears to have peaked at a much lower level than earlier expected. The process of business sector de-leveraging is moderating, with the pace of the decline in business credit lessening and indications that lenders are starting to become more willing to lend to some borrowers. Credit for housing has been expanding at a solid pace. New loan approvals for housing have moderated over recent months as interest rates have risen and the impact of large grants to first-home buyers has tailed off. Nonetheless, at this point the market for established dwellings is still characterised by considerable buoyancy, with prices continuing to increase in the early part of 2010.
… Interest rates to most borrowers nonetheless have been somewhat lower than average. The Board judges that with growth likely to be around trend and inflation close to target over the coming year, it is appropriate for interest rates to be closer to average. Today’s decision is a further step in that process.
So no mention of the true degree of labour market slack (more about this later).
I am always in two minds when it comes to thinking about these decisions. On the one hand, monetary policy is a very ineffective means of managing aggregate demand. It is subject to complex distributional impacts (for example, creditors and those on fixed incomes gain while debtors lose) which no-one is really sure about. It cannot be regionally targeted. It cannot be enriched with offsets to suit equity goals.
So, fiscal policy (when properly designed and implemented) is a much better vehicle for counter-stabilisation. However, the impact of monetary policy also has to be considered in relation to the levels of debt that households are currently holding. Australian households have record levels of debt and in the financial crisis lost a large slab of their nominal wealth. The RBA has always claimed that the debt was manageable because asset values were rising at a faster rate.
I always found the argument to be dubious given that a rising proportion of the “assets” being purchased with the increased debt were subject to significant private volatility (for example, margin loans to buy shares). But even more troublesome was the direct link between the debt-binge and the real estate booms which have pushed “investment” funds into unproductive areas at the expense of other areas of economic activity which would have generated more employment.
Part of the genesis of the financial – then real – crisis has been the skewing of economic activity towards “financialisation” and away from productive enterprise. So I found the RBA’s line unsatisfactory in that respect. Moreover, now that the household sector has responded to that sort of encouragement, the RBA thinks it is reasonable to punish the most marginal of this group with higher interest rates. Some people will default on their housing mortgages as a result of today’s decision.
The other reality is that the recession was not deep enough in Australia to really force a significant de-leveraging within the private sector. There is still considerable vulnerability there despite the rising household saving ratio.
Measures of inflation
The RBA’s formal inflation targeting rule aims to keep annual inflation rate (measured by the consumer price index) between 2 and 3 per cent over the medium term. So they have a forward-looking agenda and use underlying measures of inflation to assess the likely direction of the actual inflation rate that is published by the ABS.
The March 2010 RBA Bulletin contains an interesting article – Measures of Underlying Inflation – which explains the different inflation measures they consider and the logic behind them.
The concept of underlying inflation is an attempt to separate the trend (“the persistent component of inflation) from the short-term fluctuations in prices. The main source of short-term “noise” comes from “fluctuations in commodity markets and agricultural conditions, policy changes, or seasonal or infrequent price resetting”.
The RBA uses several different measures of underlying inflation which are generally categorised as “exclusion-based measures” and “trimmed-mean measures”.
So, you can exclude “a particular set of volatile items – namely fruit, vegetables and automotive fuel” to get a better picture of the “persistent inflation pressures in the economy”. The main weaknesses with this method is that there can be “large temporary movements in components of the CPI that are not excluded” and volatile components can still be trending up (as in energy prices) or down.
The alternative trimmed-mean measures are popular among central bankers. The authors say:
The trimmed-mean rate of inflation is defined as the average rate of inflation after “trimming” away a certain percentage of the distribution of price changes at both ends of that distribution. These measures are calculated by ordering the seasonally adjusted price changes for all CPI components in any period from lowest to highest, trimming away those that lie at the two outer edges of the distribution of price changes for that period, and then calculating an average inflation rate from the remaining set of price changes.
So you get some measure of central tendency not by exclusion but by giving lower weighting to volatile elements. Two trimmed measures are used by the RBA: (a) “the 15 per cent trimmed mean (which trims away the 15 per cent of items with both the smallest and largest price changes)”; and (b) “the weighted median (which is the price change at the 50th percentile by weight of the distribution of price changes)”.
While the literature suggests that trimmed-mean estimates have “a higher signal-to-noise ratio than the CPI or some exclusion-based measures” they also “can be affected by the presence of expenditure items with very large weights in the CPI basket”.
The authors say that in the RBA’s forecasting models used “to explain inflation use some measure of underlying inflation (often 15 per cent trimmed-mean inflation) as the dependent variable”.
So what has been happening with these different measures? The following graph shows the four (data) that are published by the ABS – the annual percentage change in the all items CPI (blue line); the same change in the CPI excluding volatile items (red line); and the annual changes in the weighted median (green line) and the trimmed mean (purple line).
Remember the trimmed measures (weighted median and trimmed mean) are designed to depict tendency or trend and attempt to overcome misleading interpretations of trend derived from the actual series.
My interpretation is that trend inflation is heading lower although it is still above the 3 per cent upper-band. The other measures are in the lower half of the RBA inflation target band.
The following graph shows the movement in the RBA Commodity Price Index (data) from January 2004 to March 2010. The index is averaged to 100 for 2008-09.
The resources boom which began in late 2005 and peaked just before the crisis really took hold is evident in the base metals series. The data shows that the overall commodity prices is not heading upwards at any alarming rate. Base metals have recovered somewhat but it is too early to say whether they will reach the heights of early 2007.
However, in the context of the Governor’s statement which implies that the terms of trade are accelerating quickly the commodity price rises are modest. It is true that the exchange rate has appreciated but this is in part due to the interest rate spreads that the RBA has engineered (given policy rates in other major nations are around zero). Further the exchange rate is reducing the inflation rate and dragging the economy down via the reduction in overall trade competitiveness.
Are these rates rising because of the federal budget deficit?
We are starting to hear from the Opposition party (the conservatives) that the deficits are “crowding out” private investment as a result of the interest rate hikes. They clearly have been studying macroeconomics from Mankiw or some other fraudulent account of the way the macroeconomy works to be thinking this.
So we get these hacked versions of supply and demand whereby the government is sucking scarce capital out of the hands of the private sector to “fund” its deficits (which are wasteful anyway) and the strain on available funds pushes up interest rates. The rising rates are then alleged to crowd out marginal investment projects.
This logic commands a powerful place in the public debate but is plain wrong.
First, the federal government doesn’t need to “fund” its net spending because it is the monopoly issuer of the currency. It just “pretends” to “fund” itself by issuing debt $-for-$ to match its net spending. This practice was necessary during the gold standard and convertible currency era but after 1971 has no relevance.
As I have explained many times, the fact that this practice continued is due to the policy dominance of the neo-liberal ideology. They knew that after 1971, fiat currency systems meant that fiscal policy was no longer revenue-constrained. But their main agenda was not to operate the monetary system to its potential but rather to hamstring fiscal policy to give more space for the private profiteering.
So they needed to mount two attacks. The first on the wages system to ensure more of the real product was available to the profit share. They have been very successful in this quest – pressuring governments to bring in anti-union legislation and diminished safety net procedures (that is, minimum wage adjustments). The second attack was on the use of fiscal policy and the promotion of monetary policy as the primary counter-stabilisation tool.
Further, the concept of counter-stabilisation now focuses on inflation rather than income and employment. This is a reflection of the NAIRU belief that if an economy achieves price stability it will enjoy maximum growth potential and full employment. There is no hard research evidence to support this belief.
As I explained in this blog – The Great Moderation – the costs of this policy approach in terms of permanent real output losses and persistently high labour underutilisation rates belie the rhetoric. The so-called “natural rate” story is just blind ideology that comes from those who have an intrinsic loathing of government activity – unless of-course it is benefiting them directly!
I should add that the government would be hawking the same nonsensical line of argument (I won’t call it reasoning) if it was in opposition. That is just a reflection of how bad the state of politics is in Australia.
Second, the government just borrows back what it spent anyway (in a macroeconomic sense). There is no scarcity of funds. The government provided the funds by its prior spending. Some will argue that while this might be so, those funds could be better used by private investors and that preference is reflected in rising yields on public bond issues.
It is clear that the public debt auctions are starting to generate rising yields as private investors gain a renewed appetite for risk and are again diversifying their portfolios. From a private sector perspective that is a good thing. It also means that the income flow coming from the holdings of public debt will be higher (slightly) which is also a good thing. It makes very little difference to the government who just credit bank accounts anyway when they repay or service their debt.
And while the economies are well below full capacity there is no urgency about the composition of public spending and the danger that the interest servicing payments might squeeze out other desired government spending or force a rise in taxes to reduce the capacity of the private sector to spend and thus keep aggregate demand below the inflation barrier.
Further, the need for debt issuance declines because the renewed private spending reduces the public deficit via the reversal of the automatic stabilisers. Remember always that the fiscal balance is endogenous and driven by non-government spending decisions. The non-government sector can always drive the budget into surplus if they spend enough.
But the rising yields do reflect the mindless practice of issuing debt in the first place. They could avoid all this political angst by just net spending and leaving the added reserves in the banking system. Sure there would be an outcry that hyperinflation was coming. But in a year or more when inflation behaved no differently to what it does now – more or less stable with spikes reflecting supply rather than demand shocks – the cacophony of angst would subside. Then it would only be the Austrian fanatics who would be shouting and who would be listening?
Finally, the budget deficits by stimulating national income growth provide increased capacity for the private sector to save which means that there are more funds available for borrowers anyway.
The reality is that in our ridiculous system of “central bank independence” (another ideological construct from the neo-liberals to reduce democracy in the policy setting process) – the interest rate rises are the sole prerogative of the RBA board. Their logic is very simple and transparent – and erroneous.
They are single-mindedly focusing on the inflation rate and aiming to keep it within 2 to 3 per cent. So anything that pushes their estimate of the inflation rate above their threshold will bring interest rate rises – an export boom; a private investment boom; a private consumption binge; and a government stimulus. Further, the inflation might not even be driven by demand-pull factors. A supply shock (in some imported raw material; or profit push from the corporate sector) will elicit the same response.
So the mechanism via which the RBA’s logic works has nothing to do with “strains on funding” or “crowding out in financial markets”. Their model is Pavlovian – you think there is an inflation threat so hike!
To give you some idea of the relationship between interest rates (measured as the interbank rate – because the available consistent series is longer than the policy rate) and the federal budget deficit as a percentage of GDP (annual data from 1977 to 2010 – the latter being to March and/or estimated). The horizontal red line is the average interbank rate over the period (8.7 per cent).
Now I wouldn’t read anything into this graph and I provide it only for interest. The causality can be working both ways. So a period of very high interest rates in the late 1980s (above 17 per cent in 1989) preceded the very harsh contraction in the early 1990s. In 1988 and 1989, the federal budget was in surplus as the self-styled “best Treasurer in the World” Paul Keating wanted to demonstrate how neo-liberal he was – for a Labor man it was disgusting. But during this period there was a positive relationship between budget surpluses and rising interest rates. But this was just correlation not causation – but should not be forgotten because it shows how mindless the conservative crowding out claims are.
As soon as the economy contracted, the budget went into deficit and this was maintained over the period of declining interest rates. But you will get some observations where high deficits are associated with high rates and of-course the causality does not go from deficits to rates.
But, in general, there is no coherent relationship between the two. As long as the federal deficits are non-inflationary they will not be associated with rising interest rates. Once the RBA gets the level of rates back to what it calls “average” or “neutral”, and that will be before the federal government eliminates its deficit – rates will stabilise again. Then there won’t even be correlations to look at, which is mostly the case shown by the graph.
So what is wrong with putting up rates?
The next graph shows the ABS broad labour underutilisation from March 1978 to March 2010. This measure adds official unemployment to underemployment but ignores hidden unemployment (arising from participation rate changes during recessions). So in that sense, it is a better indicator of the state of the labour market than the narrow official unemployment rate but still underestimates the degree of slack (hidden unemployment is currently around 2.5 per cent).
The point is obvious. The NAIRU approach to price stability uses labour market slack as a policy tool and relies on maintaining a pool of wasted labour resources for its effectiveness. You can clearly discipline the price inflation process by inducing enough labour market slack. That is a no-brainer. But the cost of this slack is enormous. The mainstream economists justify this approach by claiming (as noted above) that the sacrifice ratios (the real output losses of disinflation policies) are low and transitory.
However, this is just a blind ideological statement and the overwhelming body of research on the topic including my own indicates these real losses are large and permanent. In my recent book with Joan Muysken – Full Employment abandoned we consider these issues in detail.
But while the permanent income losses are bad enough the personal and social costs that are borne by the unemployed and underemployed and their families (especially their children) are large and long-lasting. The research evidence is very clear – children who grow up in jobless households encounter considerable labour market disadvantage themselves once they become adults – and pass it onto their children in turn.
So there is a moral outrage here as well as an economic issue. I don’t support explicit government policy that deliberately and systematically imposes costs on a disadvantaged segment of the population. I also don’t support policies that deliberately and systematically force the economy to operate below its potential.
You will note from the graph that in the so-called long boom between 1992 and 2008, the Australian economy failed to get labour underutilisation back to its previous low-point (in 1989 of 9.9 per cent). So after 16 years of continuous economic growth (barring one negative quarter in December 2000) – we could still not get our wasted labour rate below 9.9 per cent of the available and willing labour force.
And just think about it for a second: we congratulate ourselves (or the politicians do) when we have nearly 10 per cent of our willing labour resources idle year-to-year. What sort of screwed priorities does that reflect? This is what the NAIRU constraints on policy lead to. While that is bad enough, the devious way the mainstream economists then try to cover their tracks and claim the true labour wastage is low etc (there are many spurious arguments used) is a disgrace. My profession is a total disgrace!
The persistence of high rates of labour underutilisation – the wasted people potential – alone indicts the policy framework in place which was a combination of the current monetary policy (inflation targeting began formally in 1994) and a bias towards fiscal surpluses (10 out of 11 between 1996 and 2007).
So what I take out of today is that the mainstream economic policy agenda that took us into the crisis is still alive in Australia. We have been lucky this time courtesy of our association with China (an unfortunate one should I add given the human rights abuses there) and the significant and early fiscal intervention by the federal government.
But we still have very high rates of labour underutilisation and given the only durable investment we can make in the future is in our people – I think the fact that this is no longer a policy target reflects the poverty of our era.
And may I just note it here – as I am doing a lot of background research at present on this question – the real danger for global inflation in the coming years will not be the budget deficits. The susceptibility will come from the energy sector as more and more people who used to be poor but now command incomes (for example, China and India) will drive energy prices upwards. I am noting it so I can claim “that I saw it coming” (-:
I covered some of these thoughts in this blog some time ago – Be careful what we wish for …. But now I am looking into it more deeply.
That is enough for today!