The Politics of Current Monetary Policy
'Henry' provides advice to the Reserve Bank on how to persuade its political masters to allow a necessary rise in interest rates.
The Treasurer on his return from his recent trip was careful not to endorse the "no rate increase" line of his colleague Nick Minchin and his boss John Howard. We believe this is because he is well aware that rate hikes will soon be unavoidable. Indeed, as we have argued, firm pressure on the monetary brakes has been appropriate for some time now.
The reasons for rate increases are simple. Domestic demand in Australia has been growing at an unsustainable rate for more than a year. It is only global weakness that has kept monetary policy "set easy". The global economy has in fact been in recovery mode since the end of 2001, although the terror attacks and our response to these have confused the picture. This has provided a reason to delay necessary monetary tightening in Australia. The "fog of war" is a powerful fact.
Today we argue that the risks from continued monetary ease greatly outweigh the likely benefits. We believe that the Reserve Bank understands this, so we aim to help it by arguing the case for its political masters. "But the Reserve is independent" we hear you cry. Yes, but as the great monetary economist Milton Friedman once said in conversation with Henry: "Central banks stay independent by always doing what they're told." And our central bank has had plenty of advice from its political masters of late.
"Prime Minister, we understand that you wish to be re-elected" is the natural starting point for a politically-sensitive Governor briefing the PM. "The economy is strong - unemployment is falling (to levels below those in the United States), house prices are rising fast, credit growth is unsustainable, retail sales are growing strongly and the current account deficit is over 6 % of GDP. The Australian dollar is rising, although that is partly due to the decline in the US dollar, a decline that has further to run as it is a necessary part of the rebalancing of the US economy's competitiveness in international trade. There is no immediate threat of inflation.
The drought and poor international growth have been a factor in Australia's current account blowout, but now the international economy is clearly on the mend and the rural scene is looking much better. Provided domestic demand is growing at a sustainable rate - ideally around 3 % per annum instead of the recent rate of 6 %, - the current account deficit will decline to a manageable 3 to 4 % of GDP. Unless this reduction occurs, however, there is a grave risk that international investors will stop seeing Australia as a desirable place to invest. If this occurs we would see the currency drop and interest rates rise, to levels considerably above those we would otherwise engineer as part of a deliberate policy tightening.
You have pointed out, Prime Minister, that no-one has complained to you that the price of their house has risen too far. Neither do members of the Reserve Bank board so complain, all of whom have large stakes in the housing market, often with more than one substantial property. But you will be well aware that house prices cannot rise at their recent rate forever. Whether we are in the midst of a housing "bubble", and if so whether we should take this into account in framing monetary policy, has been the subject of much debate. But we venture a more basic conclusion: "History shows there has been no housing surge like the current one that has not ended badly".
We have several times discussed the extent to which Australian households have been borrowing to maintain spending in excess of their incomes and in particular to buy more expensive houses and the furniture and fittings and more expensive cars needed to complement them. Australian households overall are dis-saving, a most undesirable state of affairs. This "gearing up" means that the economy is far more vulnerable than it was to the effects of interest rate hikes. If the choice is between a moderate interest rate rise now or a much larger rise later - initiated by the international investors reducing their stake in the Australian economy - the overall economic outcome will be far better if we maintain control by initiating a moderate rate rise now.
We acknowledge that there is no immediate threat of inflation. But we note three ominous developments. Productivity growth has slowed, meaning that any given overall wage growth will add pressure to prices. Second, the state agencies, the largely unreformed employers of people such as nurses, policemen and government workers generally, are under substantial pressure to grant higher wages. Third, the frequent stories about the large amounts paid to senior executives in the private sector are building a culture of envy that will increasingly put upward pressure on wages across the board. These pressures will be maintained and increased while-ever real domestic demand continues to grow above its sustainable rate.
There is also the question of fiscal policy. We are very supportive of your aim to cut rates of income tax - indeed, we recall this was promised when the GST was introduced and it will reduced the tax advantages of negative gearing. But tax cuts are likely to add to domestic demand, and that there are also legitimate calls for greater spending on defence, health and education. Great spending restraint in all other areas will be needed if your government is to be able to responsibly offer cuts to rates of personal income tax in the next budget. Slowing the growth of domestic demand to sustainable rates now will provide more freedom of action on the fiscal front.
Our summary is simple. The safest course is to raise interest rates over the next month or so by 50 basis points. Rises larger than this hopefully will not be needed, provided the net effect of the budget is to reduce overall demand rather than to raise it. A relatively modest slowdown now will greatly reduce the possibility of a far more severe economic disruption during 2004, and is in fact the way to maximize your government's chance of securing a victory in an election held in late 2004.
If you are disinclined to take this advice, we suggest you to hold the election as soon as possible."
A lightly edited version of this paper is published in The Australian today.