{"id":12184,"date":"2010-11-03T17:56:23","date_gmt":"2010-11-03T06:56:23","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=12184"},"modified":"2010-11-03T17:56:23","modified_gmt":"2010-11-03T06:56:23","slug":"rba-makes-the-wrong-decision","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=12184","title":{"rendered":"RBA makes the wrong decision"},"content":{"rendered":"

\t\t\t\tLast month, the Reserve Bank of Australia (RBA) held its policy rate unchanged at 4.5 per cent contrary to what the bank economists expected. I said at the time in this blog – RBA confounds the market economists – but that’s easy<\/a> – that RBA made the correct decision. It reflected the fact that the world economy is still in trouble as the fiscal austerity in various places starts to bite. It also reflected the fact that the trends in the local economy are far from clear and solid evidence is available to suggest that despite the boom in primary commodity prices (from Asia) our economy is still fragile. The labour market has considerable slack (12.5 per cent underutilisation rates) and housing and sales are flat or in decline. Most importantly (for the RBA) inflation is moderating in Australia. Nothing much has changed in the meantime and I was expecting (along with all my bank economist friends) for the RBA to hold its line again. Yesterday, the RBA confounded us all and pushed rates up by 25 basis points. But even more stark was the decision by the formerly public bank (privatised by the neo-liberals) – the CBA – to push its standard mortgage rate up by 45 basis points after announcing a huge and increasing profit earlier in the week. The RBA made the wrong decision yesterday.
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\nThe day after the Reserve Bank of Australia hiked interest rates again, the Australian Bureau of Statistics released the latest data on – Building Approvals, Australia<\/a> – for September. The trends in this data is one of the indicators we use to assess the heat of the housing construction market.<\/p>\n

What is the story? Answer: Deteriorating!<\/p>\n

The ABS report that:<\/p>\n

\nThe seasonally adjusted estimate for total dwellings approved fell 6.6% and has fallen for six months.<\/p>\n

The seasonally adjusted estimate for private sector houses approved fell 2.2% and has fallen for four months.<\/p>\n

The seasonally adjusted estimate for private sector other dwellings approved fell 15.7% following a rise in the previous month.<\/p>\n

The seasonally adjusted estimate for the value of total building approved fell 3.2% in September. The seasonally adjusted estimate for the value of new residential building fell 5.4% and the value of residential alterations and additions rose 1.0%. The seasonally adjusted estimate for the value of non-residential building fell 0.7%.\n<\/p><\/blockquote>\n

The following graph (using the ABS data release today) shows you clearly which way this market is heading.<\/p>\n

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There is no hint of a building head of inflation steam heading from this source.<\/p>\n

The ABC National News<\/a> said this of the data:<\/p>\n

\nTotal dwelling approvals are now at their lowest level since June 2009 … The annualised pace of new dwelling construction dropped to 146,000 homes in September, well below the 200,000 homes many economists believe are needed annually to keep up with demand from a growing population … [they quoted a bank economist] … “the fall is a natural outcome of stimulus being withdrawn … The housing recovery in 2009\/10 was entirely due to both monetary and fiscal policy being squarely aimed at this sector during the worst of the global financial crisis” …\n<\/p><\/blockquote>\n

First, the stimulus worked and was instrumental in providing some growth in dwellings to ease the shortage. Stifling that growth will add inflationary pressures! If you want output to keep pace with demand you have to stimulate capacity. Our central bank doesn’t seem to understand that as it goes in search of the future (sometime out there in the haze) inflation bogey.<\/p>\n

Second, there is significant capacity potential that can be developed and real resources available to build it should demand rise. The economic growth that would follow would be non-inflationary. But the RBA seems to think that growth has to be curtailed now. More on that later.<\/p>\n

In the light of today’s data release the Housing Industry Association<\/a> declared war on the RBA saying that:<\/p>\n

\nThe weak housing outlook is compounded by yesterday’s interest rate hike by the Reserve Bank which, due to the additional independent 20 basis point increase by the Commonwealth Bank, will act like a sledgehammer on confidence and economic activity in the non-resource sectors.<\/p>\n

This total 45 basis point increase in home-lending rates will seriously dent new home demand and confidence, and is worrying as it follows the removal of the First Home Owners Boost and the impact of previous rate hikes.\n<\/p><\/blockquote>\n

Expect to hear that message over and over as the unelected RBA continue to think they can “experiment” with the economy and apply their NAIRU-obsessed mentality on all sectors whether they are growing or not.<\/p>\n

The RBA decision<\/strong><\/p>\n

Yesterday, the RBA surprised everyone (including me) and increased interest rates. In the formal statement<\/a> from the RBA Governor announcing the decision to increase interest rates by 25 basis points we read that:
\n… The prices most important to Australia remain at very high levels, with the result that the terms of trade are at their highest since the early 1950s … <\/p>\n

Public spending was prominent in driving aggregate demand for several quarters but this impact is now lessening. While there has been a degree of caution in private spending behaviour thus far, the rise in the terms of trade, which is now boosting national income very substantially, is likely to lead to stronger private spending over the next couple of years, especially in business investment.<\/p>\n

… the moderation in inflation that has been under way for the past two years is probably now close to ending … Inflation is likely to rise over the next few years … <\/p>\n

the economy is now subject to a large expansionary shock from the high terms of trade and has relatively modest amounts of spare capacity. Looking ahead, notwithstanding recent good results on inflation, the risk of inflation rising again over the medium term remains. At today’s meeting, the Board concluded that the balance of risks had shifted to the point where an early, modest tightening of monetary policy was prudent.\n<\/p><\/blockquote>\n

This is what they are worried about. The following graph shows quarterly movements in the RBA Index of Commodity Prices – G5<\/a> (since July 1982). It is clear that primary commodity prices are rising again and will probably get back up to where they were before the crisis hit as long as China keeps growing. Australia is a primary commodity exporter and thus enjoys these strong terms of trade.<\/p>\n

The reality though is that the export sector remains a negative net contributor to overall national income. However, the RBA is signalling that they think the resources tied up in servicing the growing export market at present (principally in mining) will strain our capacity and inflation will be the result.<\/p>\n

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The Theory and the reality<\/strong><\/p>\n

Mainstream monetary theorists – the type that become central bankers or who the central bankers read – argue that inflation targeting provides the central bank with a framework or structure which allows it to promote understanding and dialogue with the public such that inflation expectations are purged and lower interest rates sustained.<\/p>\n

They believe that inflation targeting eliminates inflationary biases in an economy because the central bank has a strong motive to maintain the policy stance.<\/p>\n

They claim that it promotes transparency, accountability and credibility – the explicit announcement of price stability as the major focus of monetary policy makes it transparent and credible. The setting of known inflation targets places a discipline on monetary authorities to avoid so-called non-optimal policy shifts.<\/p>\n

Credibility thus suggests that the public trust the central bank to maintain its nerve and act consistently to achieve price stability. Central bank credibility is considered by supporters of inflation targeting to a principle mechanism by which the economy purges inflationary expectations and risk premiums on interest rates <\/p>\n

The problem is that the RBA’s behaviour now has become totally unpredictable.<\/p>\n

They do have a formal inflation target and tell us more or less which data series they use to measure inflation.<\/p>\n

So they say they desire to keep the annual inflation rate between 2 per cent and 3 per cent. They use two major indicators of inflation which are purged of outlier tendencies: 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)”.<\/p>\n

Please read this article – Measures of Underlying Inflation<\/a> – for more information.<\/p>\n

Further, please read last week’s blog (October 28th, 2010) – Not only smokeless, but looking rusty and unusable<\/a> – which coincided with the ABS release of the latest inflation data for more information about these inflation measures and how the RBA claims they use them.<\/p>\n

So you would think that if the desirable inflation measures were within the targeted band and falling (and related measures which feed into the inflation process) were benign or also falling then the RBA would conclude it should maintain a stable monetary policy stance. That would be the transparent and accountable behaviour.<\/p>\n

But you would be wrong. In fact, they do not behave transparently at all. They achieve total opaqueness by defining the 2-3 per cent inflation target in terms of “future” inflation – a medium-term outlook. The trouble is that the medium-term is not specified in any sensible way. It is somewhere out there …<\/p>\n

The conclusion you reach is that there is no precision in this process at all. They somehow have an in-built inflation bias that sees exploding prices everywhere even when all the current indicators are soft. Apparently we will experience strong investment in the coming 2 years and that will drive inflation up.<\/p>\n

Why will it? Answer: apparently we are close to full capacity.<\/p>\n

In its – February Monetary Policy Statement<\/a> – the RBA produced this graph.<\/p>\n

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They concluded in relation to that graph that:<\/p>\n

\nFrom around mid 2009, measures of capacity utilisation began to recover, and are now back above long-run average levels … these measures suggest that the economy starts the cyclical upswing with considerably less spare capacity than earlier thought likely.\n<\/p><\/blockquote>\n

If you believe that you would believe anything.<\/p>\n

First, comparison with long-run averages conditioned by the data of the last two decades doesn’t tell us all that much because the government deliberately ran the economy at a below full-capacity level. They fell prey to the NAIRU concept (see below). The upshot was that we started to consider that the economy was “fully employed” when the reality was that there was huge volumes of labour resources lying idle for want of work.<\/p>\n

So I don’t see that we are running out of capacity any time soon although I acknowledge that the relatively small mining sector might be growing fast at present.<\/p>\n

Second, manufacturing remains in decline and will decline further in the coming months as a result of the appreciating exchange rate which is being exacerbated by the RBA pushing interest rates up further.<\/p>\n

Third, construction is slowing as a result of the withdrawal of the fiscal stimulus. The major contribution of growth in construction in the last 18 months was the large public infrastructure projects. With housing and investment property approvals in trend decline (see data above) the outlook for construction is not strong at present.<\/p>\n

Fourth, the services sector case is interesting. What capacity are we talking about in a largely labour intensive sector? Labour right!<\/p>\n

Well this graph is the latest from the latest ABS Labour Force<\/a> data. The blue line is the ABS measure of broad labour underutilisation (the sum of underemployment and unemployment), the red line is the underemployment rate and the green line is the unemployment rate.<\/p>\n

At present, the broad wastage of labour is 12.5\tper cent with the underemployment rate being 7.4 per cent and the unemployment rate being the difference. Even at the height of the last boom the broad wastage was around 8.8 per cent.<\/p>\n

These are conservative measures of the amount of labour that is being wasted because it excludes the hidden unemployed (who exited the labour force) and the other categories of marginal workers who could work if there were the right set of conditions. <\/p>\n

But the 12.5 per cent represent idle work hours available from workers who are active, ready and willing. There is nothing marginal about that wastage.<\/p>\n

It is often claimed that these workers (1.2 million odd) are not skilled enough to take the jobs that are emerging. This is the NAIRU nonsense that tries to claim that most unemployment is structural and therefore imposes an inflation constraint beyond which growth in nominal aggregate demand cannot be met with real output and employment increases.<\/p>\n

Please read my blog – The dreaded NAIRU is still about!<\/a> – to disabuse yourself of this sort of argument.<\/p>\n

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The NAIRU concept does not stack up theoretically or empirically. It is well established that changing labour market imbalances reflect cyclical adjustment processes which render any estimated macroequilibrium unemployment rate to be cyclically sensitive and therefore not the basis of an inflation constraint.<\/p>\n

The NAIRU hypothesis suggests that any aggregate policy attempt to permanently reduce the unemployment rate below the current natural rate inevitably is futile and leads to ever-accelerating inflation. The vertical Phillips curve is accepted by most economists, monetarists and Keynesians alike.<\/p>\n

However, the empirical world supports the notion that imbalances reverse when aggregate demand regains strength. The last thing we should be doing at present is to abandon job creation policies and start thinking that training programs and worker-attitude-correction strategies will produce any jobs.<\/p>\n

Please read my blog – The structural mismatch propaganda is spreading … again!<\/a> – for more discussion on this point.<\/p>\n

I remind you of this insight from Michael Piore (1979: 10) which remains true today:<\/p>\n

\nPresumably, there is an irreducible residual level of unemployment composed of people who don’t want to work, who are moving between jobs, or who are unqualified. If there is in fact some such residual level of unemployment, it is not one we have encountered in the United States. Never in the post war period has the government been unsuccessful when it has made a sustained effort to reduce unemployment.<\/em> (emphasis in original) [Unemployment and Inflation, Institutionalist and Structuralist Views, M.E. Sharpe, Inc., White Plains]\n<\/p><\/blockquote>\n

But think about the service sector capacity. These jobs are mostly low-paid, low-skilled positions which require minimal training. So even if the 12.5 per cent of idle workers cannot drive a complicated piece of mining equipment (and I even would contest that claim) they can certainly flip a few burgers or whatever. So the claims about the service sector being close to exhausting its capacity have to be seen as ludicrous.<\/p>\n

In this context, the central bank is captive to the following basic propositions which represent a “consensus” position among mainstream monetary economists (taken from Masson et al.<\/em>(1997) ‘The Scope for Inflation Targeting in Developing Countries’, Working Paper 97\/130<\/em>, International Monetary Fund):<\/p>\n

\n(1) An increase in the money supply is neutral in the medium to long run; i.e., a monetary expansion has lasting effects only on the price level, not on output or unemployment.<\/p>\n

(2) Inflation is costly, either in terms of resource allocation (efficiency costs) or in terms of long-run output growth (breakdown of ‘superneutrality’), or both.<\/p>\n

(3) Money is not neutral in the short run; i.e., monetary policy has important transitory effects on a number of real variables such as output and unemployment. There is, however, at best an imperfect understanding of the nature and\/or size of these effects, of the horizon over which they manifest themselves and of the mechanisms through which monetary impulses are transmitted to the rest of the economy. And, a corollary of (3).<\/p>\n

(4) Monetary policy affects the rate of inflation with lags of uncertain duration and with variable strength, which undermine the central bank’s ability to control inflation on a period-by-period basis.”\n<\/p><\/blockquote>\n

So in turn:<\/p>\n

(1) They believe that monetary policy influences the money supply and it has no medium to long run on real output or employment. That is, the NAIRU nonsense. They deny that there are any lasting real effects of scorching aggregate demand.<\/p>\n

Please read my blog – Inflation targeting spells bad fiscal policy<\/a> – for more discussion on this point.<\/p>\n

(2) They consider inflation to be more costly than persistent unemployment even though the latter costs economies millions of dollars of lost income every day and damages peoples lives irretrievably when the duration is long. There has never been credible evidence that modest inflation is costly.<\/p>\n

(3) Monetary policy does suppress real output and employment in the short-run but they haven’t got a clue about these impacts – they do not know:<\/p>\n