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Henry Thornton - Economics: A discussion of economic, social and political issues Monetary policy and exchange rates Date 21/11/2004
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Why have credit standards been progressively relaxed, until the RBA governor and head of Apra find it necessary to chastise the banks?


Could it be excessively easy monetary policy?

And what will happen if the Aussie dollar continues to rise?


Read on here ...
By PD Jonson Email / Print

The Economist discusses the global currency "crisis."  "... according to Stephen Jen, an economist at Morgan Stanley, the crisis that befell Asia seven years ago may be about to repeat itself. Only in reverse."


In Australia, the most relevant discussion is by Terry McCrann for the Oz.  He presents what I take to be the RBA's views.  If the Aussie dollar rises too far as the US dollar falls, the remedy, consistent with the strict inflation targeting that the Reserve seems to be taking may well result in interest rate cuts.  Asset and credit bubbles, balance of payments imbalances, all are strictly secondary, to be taken into account only to the extent they influence the likely future course of inflation.


Now I hope I have captured the McCrann/Macfarlane view corrently - since I am now going to put another case.


I agree the Reserve should have as a primary objective control over a measure of goods and services price inflation ("CPI inflation").  I also agree that inflation control will maximise growth and minimise unemployment, as I argued in public in 1990 and within the RBA well before that.


"Inflation targeting" is a primary objective for the RBA as a result not of legislative change but rather an "exchange of letters" with the Treasurer.  I shall leave the legal ramifications to constitutional lawyers, and accept the premise of the exchange of letters, while keeping the whole Reserve Bank Act in mind, as I feel sure Ian Macfarlane does.


The Reserve bank act, of course, has 'stability of the currency' prominant in its list of objectives that the Reserve is meant to control - that is why the Governor recently gave a speech on the subject of financial stability.


The trouble with placing total, or even primary, weight on CPI inflation is that the traditional warning signs of excessive credit and asset growth and an excessive current account deficit are given too little weight.


The likely outcome in practice is obviously a matter for judgment, which is why total weight cannot be placed on CPI inflation.  My point is that asset and credit bubbles, accompanied by an unsustainable current deficit, are likely to lead to "instability of the currency."


If the Greenback keeps falling, for example, the US Fed will accelerate its monetary tightening and this will at some stage make international investors withdraw capital from Australia, at which point the Australian dollar will fall sharply, not rise as it has been doing recently.  Anticipating this, the RBA would be more likely to raise interest rates rather than cut them.  Cutting interest rates with a strong economy, high asset prices and a large current account deficit would be likely to turn a modest decline in the value of the Aussie dollar into a severe decline.


By no definition would this be called "stability of the currency."  Instability of the currency - especially downward instability -  would be highly likely to raise inflation.


This is why the RBA cannot ignore the traditional indicators of asset and credit inflation and the current account deficit.


And the most important question of all is why have the banks relaxed their prudential standards?  Easy monetary policy is the obvious answer, not that The RBA can bring itself to admit this, except perhaps to itself in rare moments of introspection.


Further discussion, including some relevant historical analysis, is linked here.


Nigel F, 22/11 writes:  "Mr Jonson is right to say "the RBA cannot ignore the traditional indicators of asset and credit inflation and the current account deficit".
 
Mr Jonson is not alone. The director of the research and statistics department of the Bank of Japan said in April 1994: "What is clear now is that  the cost of accomodating the economic boom, which saw tremendous land price hikes in the second half of the 1980s, was very high".
 
Ian Macfarlane, the Governor of the Reserve Bank, has already made statements that acknowledge the effect that spiraling credit could have within the "medium term" on economic growth and, consequently, on inflation.
 
In August 2003, Macfarlane told the House of Representatives Standing Committee on Economics, Finance and Public Administration “… if over the next 18 months the world economy does turn out to be much weaker than we expect, there is no recovery and it just sinks down further, and if the speculative activity in house buying and borrowing – the credit driven house spiral – also continues over the 18-month period, then you would be setting yourself up for a very nasty explosion, which would cause a huge amount of financial distress and, almost certainly, a large recession”.
 
The RBA lifted the cash rate in November and December 2003, at a time when CPI inflation was well within the RBA's target levels (the annual change in the CPI in the December quarter of 2003 was 2.4%, down from 3% a year earlier).
 
But was the RBA's actions late last year strong enough and was it too late? The RBA says that monetary policy's setting is still accomodative. Australia households continue to spend more than they earn. Household credit in Australia has continued to grow rapidly and the market expects further very strong growth in the next two years. All the while, Macfarlane admits, belatedly, that credit standards have slipped in Australia.
 
Since August 2003, the global economy has strengthened. Recently, however, global growth has been revised downward. Oil prices have spiralled upwards. There are concerns that the Chinese economy may slow significantly. The IMF has found that housing prices are well above fundamental value. The Bank of International Settlements reckons mortgage prices do not fully reflect risks. The pundits worry about a significant devaluation in the US dollar and the resulting effects on global economic activity and domestic inflation.
 
The fact remains that Australia's policy makers have not done enough to avert, or soften, the kind of scenario painted so lucidly by  Macfarlane in August 2003.


20/11, Alex Erskine comments as follows:  "I read The Economist article carefully. If Asian currencies are going to be re-valued back to pre-97 levels, there is scope for the A$ to rise very sharply further ... remember we fell below US$50c in a drastic over-reaction to the Asian crisis (which I egged on, saying it was justified). Some of our current rise to US$0.80 to the market speculating on the Asian realignment using the A$ as a more liquid instrument, and some of it is the terms of trade rising to well-above-97 levels. Neither have been fully captured in the A$ yet.


I think where McCrann/Macfarlane are wrong is that the policy error has already occurred - keeping rates too low for the last 2.5 years - and there is now no scope to loosen further. Had Macfarlane tightened more and earlier, he could well have scope to ease if the A$ were to rise in the Asian realignment.


I was much impressed by Alan Greenspan's speech from earlier this year. See the 6 pages at this link. http://www.bis.org/review/r040512a.pdf
or http://www.federalreserve.gov/boarddocs/speeches/2004/200405062/default.htm


He notes how global specialisation and innovation, more efficient resource allocation investment processes and a reduction in 'home bias' amongst global investors are making larger current account deficits possible, even for such a big borrower as the US. Current account deficits are of course an excess of domestic investment over domestic saving. He is confident that there can be a market adjustment  - involving all asset prices - to reduce the US deficit if it becomes too big. [I'd add that the market adjustment seems to be underway.]

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