The Reserve Bank would be irresponsible not to raise interest rates when its board meets today.
After rising solidly for several years, money growth has exploded - as shown in the graph - to cap off the case for alarm over our inflation prospects.
The relation between money growth and inflation is a complicated matter with many nuances, but you don't have to be an unrestricted "monetarist" not to be surprised that both actual and underlying inflation is on the rise.
The Reserve Bank, however, has unhappily been surprised.
In the year to December, “headline” goods and services (CPI) inflation in Australia was 3.0 %. Right at the top of the Reserve’s “target band” of 2 to 3 %. This itself was probably above expectations, but not so far that immediate action was demanded.
However, the Reserve has decreed that it will be guided more by measures of “underlying” inflation – measures that remove rises or falls in goods and service prices deemed to be outliers – either too large or too small. Just to keep us on the ball, it developed two measures of underlying inflation – the “trimmed mean” and the “weighted median”. These measures of inflation were 3.4 % and 3.8 % respectively in the year to December.
This I feel confident was an unhappy surprise, for the Reserve if not for regular readers of this column. It is an unhappy surprise that demands the response of higher interest rates, for reasons I shall come to. First, however, some comments on political economy.
Fortunately for the Bank, the Rudd government fully recognizes the risk of inflation and is vigorously doing two things. The first is blaming the Howard government for its failure to properly manage the economy – how sweet that line must be to deliver. The second is to shape its whole economic policy around the primary aim of putting the tiger of inflation back into its cage.
I do not need to play the blame game except to note that the Reserve has as its most important task the control of inflation. It has been given the tools – a floating exchange rate and a deregulated financial system - its officers have had their salaries (and pensions) greatly increased and the organisation has been given “independence” from political government.
All this former central bankers such as Jock Phillips, Sir Harold Knight, Bob Johnston and Don Sanders fought for and won. The more recent holders of their high offices were favoured by extraordinarily low global inflation but ignored the obvious warning signs and now we all must pay the price.
The price will include the necessary higher interest rates at a time of considerable uncertainty and angst in the global economy.
We leave for another day the question of what is an appropriate sanction if an independent central bank fails to contain inflation. When the government was ultimately responsible, the electorate could sack it.
There will be those who try to resist the necessary hikes to rates – not including Mr. Rudd and his government I am pleased to note. What will their arguments be?
The first is that conditions internationally are dangerous. Even if “dangerous” can be ruled out, the slowing of global growth now generally predicted – most recently by the International Monetary Fund (IMF) – will slow the Australian economy without further rate hikes.
Note that the IMF’s latest forecast for global growth of 4.1 % is still a very high rate of growth, almost certainly still above the world economy’s non-inflationary rate of growth.
I note also that if the global economy were to slow to the extent that global inflation was again less than Australia’s 3 % plus rate, the need for Australia to reduce its inflation would be even greater than seems likely now. Retaining Australia’s international competitiveness is a major reason for keeping Australian inflation relatively low.
Of course, there could be some financial disaster lurking about – such as the collapse of a global bank or a geopolitical crisis that sends the price of oil through the roof – sufficient to trigger a severe global recession. In fact, if the Reserve does not raise interest rates today, readers would be entitled to assume they know more than the rest of us, including the IMF, does. The appropriate response if that were the case would be to go even deeper into one’s economic bunker.
The second reason that might be advanced for not raising interest rates would be that the government’s actions will do the job, and that interest rate hikes would amount to overkill. The government’s proposed actions include a somewhat tougher fiscal policy and actions to raise efficiency and increase skills in the Australian economy.
On fiscal policy, I very much doubt that even a strong government in its first year could produce sufficient tightening to make a difference to inflation in the next year or so. Perhaps through Herculean efforts the budget surplus might be raised to 2 % of GDP. This would have no-where near the impact of the Menzies government’s credit squeeze in 1960, which was the last time a tough budget produced a quick, marked reduction of inflation. (This just about cost Menzies his job, and also just about put Henry’s father out of business, incidentally.)
The other policies are all worthwhile and if implemented well will help Australia in the next decade, especially in its second half. But they will have none but a psychological benefit in the next year or so.
There is also the likely impact of Labor’s industrial relations (IR) policies. Under the previous government, liberal use of special immigration visas for “skilled” workers plus WorkChoices had noticeable effects in restraining labour costs and increasing growth of jobs. Partly because of these effects, there is pent up demand for wage hikes. One must ask whether the Rudd government will be able to restrain wage hikes despite IR ‘rollback’. The Reserve Bank needs to give much thought to this matter.
A third possible reason for caution in hiking rates is fear that the economy is already slowing. The Pollster Gary Morgan, whose consumer confidence measure dropped substantially in January, is in this camp. One must recognize that all official statistics yet released – including December quarter inflation - provide rear-mirror views.
That said, growth of retail sales, jobs, credit and all other relevant statistics from the economy in late 2007 show an economy growing unsustainably fast. Even house prices are rising again, in some cities (including Melbourne) at scary rates. To be sure, there has been a lot of equity price deflation, as part of the global financial crisis, but not so far at least to be of sufficient concern to override all the other measures of economic strength.