Because the Reserve Bank Governor, Ian Macfarlane, has now been re-appointed for a further three years from September, the dynamics of RBA Board meetings should change. Relieved of the worry that he might flick a hospital pass to any immediate successor, the Governor can now concentrate on fixing the housing bubble/excess demand problem he and his Board have created.
He and his Deputy, Glenn Stevens, should be reflecting privately that the RBA Board has run serious risks by keeping monetary policy set easy for all of 2002-03. Demand continues to outstrip supply in the Australian economy. With little that can be done to boost supply in the short-term, higher interest rates seem to be the only instrument available to squeeze growth of domestic demand down to a more sustainable rate (a temporary rise in the rate of the GST is probably in the "too hard" basket). As global growth picks up, higher interest rates would close the widening - clearly unsustainable - gap in Australia's balance of payments. And it is becoming more urgent to stop the housing bubble: the choice is a bit of a bust now or a far bigger bust later.
This means Governor Macfarlane will have to directly confront the view being argued from Canberra. His fellow ex-officio board member, the Secretary of the Treasury, Ken Henry, apparently has been advocating a cut in interest rates because Australian output growth is slipping below potential and because there is a global downturn.
We see the Treasury view is a distraction, overtaken by events, in particular by the appalling resurgence of the trade deficit. Market analysts are now talking of a return to a current account deficit of more than 6% of GDP, the level at which Australia has often experienced an interest rate and exchange rate crisis. The graph reminds us of three key dates - 1959-60, 1980-81 and 1989-90 - when crisis ensued.
The Governor also needs to take advantage of the chink of light beginning to shine in the housing market. While some have argued that the only thing between the Australian public and an interest rate cut is the RBA's "obsession" with house prices, the housing mania persists, encouraged by aggressive advertising. House prices, auction clearance rates, average loan sizes, affordability and other indicators all suggest a boom out of control. However, there has been some welcome news that apartment prices in some of the more speculative markets are at last exhibiting some weakness. This provides an opportunity to deliver a sharp uppercut to the property spruikers, by raising rates. This will not be popular, but one cannot make an omelette without breaking eggs.
Henry's forward-looking Taylor Rule maintains that a country's policy interest rate is normally the sum of two components, the usual real interest rate (which we estimate is some 3%) and the inflation rate (now 2.7%, which makes a total "normal" interest rate of 5.7%, a full 1% above the current rate set by the RBA). When the Board comes to consider whether to deviate for this normal rate and by how much, it must review whether forecast economic growth or inflation outcomes are broadly satisfactory.
By good fortune, developments in July have been broadly offsetting. Local news has shown domestic demand growth to be still too rapid, especially in view of weak export growth, but overseas news suggests that fears of persistent weakness in global demand have been overdone. Inflation concerns have also lessened during July. The June quarter CPI release signalled that prices had been flat in the June quarter, but were 2.7% higher than a year earlier. The new TD-Melbourne Institute monthly inflation index also shows inflation decelerating. The drop in world oil prices post-Iraq and the stronger local currency have clearly helped secure this result.
Global economic recovery, reinforcing better seasonal conditions in Australia, will eventually fix the weakness of exports. The most important recent news has been the signs of life in the US economy, which has forced bond yields higher around the world. A steeply positive yield curve (long-term bond yields higher than short-term interest rates) has almost always signalled better times ahead.
Other international news in July also suggests we can be more sure of global economic growth. Japan has begun to contribute to global recovery, with a sharp jump in sentiment based on evidence that companies have de-leveraged and are now hunting for new business opportunities. The tourism sector seems set to recover as fears of SARS diminish, and fears of depleted oil supplies and ever-higher oil prices have receded.
To round off this more buoyant state of affairs, we note that the extreme upward pressure on the A$ seen earlier in the year has lessened in July with the better news from the US economy. While we see the A$'s respite as only temporary, and warn that wage growth must be kept under tight control if competitiveness is not to be lost, the recent relapse does make room for an interest rate rise.
The urgency underpinning our long-held view that Australia would benefit from higher interest rates has heightened through July. The housing boom needs to be ended now and growth of domestic demand slowed, so that the current account deficit declines to a sustainable 3 % of GDP. We already have enough foreign liabilities and do not need aggressively to add to them. The RBA can do Australia a favour by raising interest rates tomorrow.
Henry Thornton is the nom de plume of a prominent virtual economist. Daily commentary can be found from Henry and colleagues at: www.henrythornton.com.
An edited version of this article appeared in The Australian today.