A full and honest account of the debate over interest rates must start in the late 1960s when global inflation began to infect the Australian economy.  At this time many rates of interest were still controlled by centralized fiat.  In particular, lending rates by banks were controlled, especially mortgage rates.  Even bond rates were held down by special rules about holdings of government bonds by banks and insurance companies.

Think of the hot mud springs at Rotorua.  Think of a large, god-like figure, trying to stop the hot mud from spurting into the atmosphere.  The more spurt points he controls, the greater the pressure that will be released from the uncontrolled spurt holes.  Total control is impossible.

The first graph shows US and Australian CPI inflation from the late 1960s. The other two graphs summarise Australia’s changing financial market history.  The second graph shows Australian bond rates against US bond rates.  The third graph shows bill rates in relation to cash rates and home lending rates.

The hot mud springs is the right analogy for the Australian economy in the 1970s.  The shameless economic incompetence of the Whitlam government meant that inflation quickly became a major problem – peaking at 17.6 % in 1975.  Cash rates and bond rates were held down and mortgage rates were controlled.  Only bank bills were uncontrolled.  When the inevitable crisis hit, bill rates spurted to 22 %, while mortgage rates, and to a lesser extent bond rates, were held back.

The Whitlam government had a “good” record on mortgage rates, since they were held down by government fiat.  But of course with rates artificially held below any reasonable market clearing rate there was a cost – mortgages were rationed.  For many borrowers bank funding was just not available, except perhaps (very expensive) borrowing backed by bank bills, whose rates were not controlled.  The spike in bill rates was a case of a big mud spurt as most other outlets were blocked.

The Fraser government, with John Howard as Treasurer, began to deregulate the financial system and ran far better monetary and fiscal policies than Whitlam.  Mortgage rates were still regulated, however, being subject to caps which were only gradually raised, but which reached 13.5 % in 1982.  Once again bill rates hit 22 % as the free financial market reacted when others were wholly or partly controlled.

The Fraser government’s moderately disciplined fiscal policy was abandoned when it was facing electoral defeat in 1982/83.  The splurge of spending created a then record budget deficit (which is still a record as a ratio to GDP) and provided inflationary pressures for the incoming Hawke government.

Throughout the Fraser government’s time in office, global inflation was reduced somewhat and US bond yields declined accordingly.  Australian bond rates first rose – catching up with market rates following deregulation – but later declined, but more slowly and by a lesser amount than US yields.   Australia was not yet the virtuous economy it was to become.

In 1981, US Fed Chairman Paul Volcker decided gradual monetary policy tightening was not doing enough to eliminate inflation.  He announced new operating procedures for monetary policy, which was tightened abruptly.  Volcker had a commanding physical presence and quickly created a sense of powerful purpose.  The Volcker recession was short and sharp and broke the stick of inflation.  The falls in US bond rates were equally as impressive as the fall of US inflation.  Australian bond yields also fell but by less, as Australian inflation was still persistent, despite gradual progress.

The Hawke government elected in 1983 chose currency depreciation over interest rate hikes as the immediate solution to the currency crisis that accompanied the last week of the election campaign.  This in itself was inflationary.  But within a year the Australian dollar was floated, an action that for the first time gave Australia the technical ability to control inflation.

Prime Minister Hawke formed an “Accord” with the ACTU which, to the surprise of conservatives, helped contain inflation.  Throughout the 1980s inflation fell in fits and starts but remained well above US inflation.  The Australian dollar was depreciating, falling especially sharply during the “banana economy” crisis of 1986.  Bond rates fluctuated around 14 % or so throughout the 1980s. 

Cash rates and bills rates peaked at 22 % in 1981, at 20 % in 1983 and at 18 % in 1989.   Housing lending rates were fully deregulated only by the Hawke Government and reached a peak of 17 % in 1989.  This is the basis of the current government’s claim that it has held interest rates well below those of the most recent Labor government.

This is true, but there are two crucial caveats.  The Hawke government made gradual progress against inflation, but in retrospect can be criticized for excessive gradualism in the application of anti-inflation policies.  Also, its financial system deregulation released forces that drove housing lending rates up from an artificially low base caused by earlier regulation of lending rates.  The resulting upsurge of lending by banks (and other financial institutions) was part of the great credit expansion of the western world whose ultimate consequences are still uncertain.

The boom of the 1980s was followed by the “recession we had to have”.  This was triggered by a wages breakout and a sharp tightening of monetary policy – arguably the degree of tightening was a mistake but turned out to be the Australian equivalent of Paul Volcker’s short sharp shock that fixed US inflation for a generation.

Following this recession, cash rates, bill rates, bond yields and bank lending rates all fell sharply.  For the first time since the 1960s, Australian interest rates were close to US rates.  Paul Keating unexpectedly won the 1993 election but then the Howard government won office in 1996 – just as interest rates were approaching a generational low point. 

The Howard government undoubtedly deserves much credit for keeping rates low and especially for policies that have maintained strong growth and greatly reduced the rate of unemployment.  It deserves much praise for giving the Reserve Bank a charter to fight inflation independent of political government, just as the Bank itself deserves praise for using that freedom to act. 

But it must also be noted that there has been a gradual but distinct rise of Australia’s rate of inflation since the late 1990s, and that interest rates are rising inexorably in response.

It is not my intention to allocate points in this great debate.  Australian voters are intelligent people and economically literate and will draw their own conclusions.

I would, however, make the point that the 50 years of interest rate history shown here emphasizes “exogenous” factors - the role of international factors (especially inflation) and changes to the regulatory framework - more than the skill and competence of governments and central banks, although both governments and central banks are undoubtedly more economically skilled now than they were 50 years ago.

Overspending by governments and loose monetary policy created the great inflation and high interest rates of the 1970s.  Deregulation, tight monetary policy (led by the USA) and the consequent great reduction of global inflation greatly reduced interest rates.  Now a global resurgence of inflation is putting upward pressure on interest rates.  So far this pressure is not dramatic, and could readily be reversed.  But if it is not soon reversed, the world will need another Paul Volcker to re-establish a climate of goods and services price stability and low interest rates.