It’s never as bad as it seems when it’s bad, and it’s never as good as it seems when it’s good.
This should be the mantra of any serious economy watcher, forecaster or central banker with the task of restraining inflation.
It should be firmly in the minds of members of the Reserve Bank board when it meets today.
When the world economy was apparently falling apart about as fast as it was at the start of the Great Depression some measure of alarm was excusable. In the major developed nations, and in Canberra, ‘panic’ is not too strong a word for policy action in 2008 and early 2009. Globally, massive fiscal stimulus was the result, with monetary policy eased to a point where nominal rates of interest were practically zero, ‘real’, ie inflation adjusted, cash rates were negative and money was being printed and disbursed – so-called ‘quantitative easing’.
The Reserve Bank of Australia, relative to the major nation central banks, cannot be accused of panic. Its large cuts in cash rates over a short period showed a welcome bias for action after the relatively timid rate hikes – too little, too late - during the boom.
Now RBA governor, Glenn Stevens, has said that cash rates are at ‘emergency’ levels and will need to be raised as the economy recovers. So now the question is when to start returning rates to more normal levels and how fast to do this.
My advice, with apologies to Treasury head Dr Ken Henry, is contained in the headline – ‘go early, go hard, go rates’, as in rate hikes.
But while this is the desirable general approach, what is implied by the point that it’s never as good as it seems when it’s good?
Caution is needed in evaluating just how good it really is right now.
The good news about the global economy can be summed up in three propositions.
1. The dramatic falls in production and jobs in the major developed nations of the USA, Europe and Japan are slowing, to the point that stabilization seems not far away.
2. China and other developing nations are still growing quickly although in China a sudden reduction in the pace of bank lending may enforce a slowdown in this half-year.
3. Global goods and services inflation is subdued, although asset markets have been showing considerable resilience – the excess money created during the global panic has to go somewhere.
There is of course a vital caveat in each of these points, and I am confident the Bank’s staff will emphasise the caveats in their presentations. And beyond the immediate caveats, there is the enormously difficult question of how central governments and national central banks can fine tune the removal of fiscal and monetary stimulus as recovery gets underway.
In assessing the state of the Australian economy, there is also considerable good news. My list of the three most important is as follows:
1. Unemployment has not so far risen nearly as fast as feared a year ago when the full horror of the global credit crunch was becoming evident.
2. Retail sales have been surprisingly strong, buoyed by the government’s stimulus packages.
3. Business fixed investment seems to be holding up better than expected, though still falling – ie the pace of reduction is slowing.
The caveats to these domestic developments will presumably also be emphasized by the staff of the bank. The first is that there is far more wasted resource in Australia’s labor market than acknowledged in an official rate of unemployment of 5.8%. This of course is helping to restrain wage claims and thus has some beneficial side effects.
I hasten to add that reducing the wasted labor market resource is a task for government, and its tax and welfare policies in particular. For the central bank, it can be no more that a fact that moderates the speed with which it removes monetary stimulus.
Strong retail sales, and the associated revival of consumer confidence, owe a lot to the stimulus packages. The stimulus effect will fade – indeed needs to fade – as private, unstimulated activity builds. Strong business fixed investment is a vital part of a strong ongoing economy, but the caveat is that, like overall activity in the major economies, it is falling less than expected, not (yet) rising in a strong and sustainable way.
These caveats to the picture of stronger than expected economy, plus considerable uncertainty about the strength and timing of economic recovery, should give the board sufficient reason not to begin tightening monetary policy today.
However, inflation, broadly defined to include asset inflation, needs careful attention. While actual goods and services inflation is within the Reserve Bank’s target zone, both underlying goods and services inflation and inflationary expectations are above the target zone and possibly rising.
Furthermore, continued asset inflation, including the apparent recovery in house prices and further increases in equity prices, are further warning signs that should be monitored closely by the Reserve Bank.
The Reserve Bank has indicated that it takes asset inflation into account, but not how it does this. It has said that ‘normal’ cash rates are well above current rates – perhaps in the range either side of 6 %. This is consistent with the ‘Taylor rule’ calculations presented by Henry in the first article in this series in June 2002.
Moving cash rates from 3 % to 6% requires 12 25 basis point increases or 6 50 basis point increases.
My advice for the board is to wait for another month. But if current trends persist, the move to a more normal cash rate of around 6 % should occur briskly and in 50 basis point chunks. If current good news trends continue, the first such chunk is likely next month.
Go early, go hard, go rates.