Monetary policy cannot successfully operate by looking in the rear view window. Nor can it make do with reports from the current economy, no matter how well-informed. The problem is that monetary policy takes time to influence the economy, so central bankers have to act on where they think the economy will be in a year or two.
This is why all the knee-jerk reaction by bank economists, screen jockeys and journalists to a particular piece of economic data is so irrelevant. Some months an especially strong jobs result (a glimpse in the rear-view mirror) produces a chorus of ‘rate hike to come’. Then a slightly lower than expected goods and services (CPI) inflation outcome (another glimpse in the rear-view mirror) causes the pundits to assert that the Reserve Bank has time to think before it raises interest rates. Both responses are irrelevant.
The problem with being a central banker is that one comes to live in the future. Like any other serious job, total immersion is required. The challenge of total immersion in the uncertain future is that it can be difficult to return to the present on those rare occasions that require attention to the here-and-now.
The task facing the board of the Reserve Bank today is to decide whether, with current (and projected) policies, good and services (CPI) inflation in a year or two will be above or below the ‘target range’ of 2 to 3 %. Question one is where will the world economy be in a year or two? The staff of the bank may have access to global forecasts that they trust, but this writer does not so we shall have to go country by country, the old fashioned way.
The US Fed is deeply concerned about weakness of the US economy and is contemplating more ‘quantative easing’, which means printing money. Printing money is inflationary, but unemployment at close to 10 %, and underemployment perhaps of the same order to this is deflationary. These factors may be assumed to be approximately offsetting, but a cautious Governor might feel the inflationary risk is the greater risk.
Euroland is mostly just as depressed as the United States, with the exception of Germany, so similar logic prevails. However, there is the additional factor of Euroland and American sovereign debt to consider. The western prosperity of the past thirty years has been built on growth of private debt. Expectations about future sovereign debt have exploded because of the dramatic easing of fiscal policy designed to limit the negative effects of the global financial crisis. While I have warned of the dangers of driving with eyes on the rear-view mirror, the lessons of history, properly understood, are the best guide to the likely future.
There are two main historical responses to sovereign debt – default or inflation. Default may seem the better option if the debt is mainly owned by foreigners, unless they can retaliate, while inflation may seem better if the debt is mainly owned by a country’s own people. The United Kingdom is trying the ‘third way’ – the conservative approach of fiscal austerity, which if maintained will in due course provide useful evidence for the great debate on ‘Keynesian’ verses ‘Austrian’ approaches to economic management.
My money is on inflation as the policy choice of Americans and Europeans other than Germans and current day Austrians. Both these groups have had searing historical experience of hyper-inflation and can safely be assumed to be inoculated against the bacillus of inflation. But others have yet to experience really damaging inflation and should be assumed to choose the soft option.
China, India and other rapidly developing nations are vitally important countries whose recent policies have been inflationary. The rear-view measures show China’s goods and services (CPI) inflation to be 3.6 % and rising; India’s 9.9 %, down from 11.7 %; Brazil 4.7 % and rising; Russia 7.0 %, down from 10.7 % and Indonesia 5.8 %, up from 2.8 % a year ago. Overall, not a cheerful rear-view view for a central bank whose main objective is keeping goods and services inflation within a tight band.
Then there is Australia’s own history of allowing inflation to get out of hand. The great inflation of the early nineteen fifties was quenched with the help of a ‘horror budget’. The Whitlam government (and Treasury) badly misdiagnosed the global inflation of the early 1970s and ignored the Reserve Bank’s correct diagnosis. Madly expansionary fiscal policy and poor industrial relations infrastructure added to the pressure of global inflation to take Australia close to a constitutional crisis as well as double digit unemployment that took a generation to fix.
The Reserve Bank itself failed in its diagnosis in the two thousands. China’s deflation was mainly responsible for low global and Australian inflation, but credit was given to the newly ‘independent’ Reserve Bank and its supposedly effective anti-inflationary policies. When Chinese deflation ceased to be of overwhelming importance, and Australia’s terms of trade exploded upwards, the Reserve moved too little too late to head off inflation. Highly relevant warnings from people with the runs on the board were ignored, and the reputation of the RBA was only saved by the onset of the global financial crisis. Even so, goods and services inflation shocked on the upside in reaching 5 %, dangerously in the red zone where inflation would have became seriously worrying.
Now Australia is again enjoying extraordinarily high terms of trade, strong momentum of employment trends and expectations of another major surge in business investment. The question that must be answered by the board of the Reserve today is this. Should these powerful expectational forces be met with a pre-emptive 50 basis point hike in cash rates, or will a 25 point touch on the brakes do the job, or can the Reserve afford again to sit tight and await further evidence of an economy headed into the red zone?
I refer with appropriate modesty to my column of 7 November 2006 – ‘The case for a pre-emptive strike’.
Published today by The Australian - sans final sentance.
Courtesy RBA - note new record high.