Bubble, bubble, toil and trouble ..
Updated: May 2, 2020
"Bubble, bubble, toil and trouble for the RBA Board and for borrowers."
Bubble, bubble, toil and trouble .
.Today’s Reserve Bank Board meeting will be the most momentous since late 2003. The Board confronts scenarios that could substantially discredit government policies or severely dent the Governor’s reputation, and both outcomes are possible. The Governor has ventured some distance out on a limb, advocating pre-emptive tightening to tackle incipient inflation. Although this is far later than Henry Thornton recommended, and this lateness has produced avoidable risk for the Australian economy, we support the approach at this time.
We also support what will almost certainly be a gradual tightening, starting with a modest 25 basis point increase in cash rates under official control. Australia’s households have accumulated debt far too quickly, a major consequence of delayed monetary policy tightening. But inappropriate fiscal incentives to borrow are also a root cause, as Governor Macfarlane has recently pointed out.
Australia’s current account deficit – a measure of the gap between domestic demand and Australia’s overall supply – is also too large, a fact that puts Australian monetary policy in “the hands of the market”. If global investors decide that the economic prospects here are more subdued, as the inflation outlook dictates, there could be an old-fashioned current account deficit crisis, at which time the Reserve would have to step in with a powerful tightening of monetary policy.
Now is not the time for heroic sharp tightening of monetary policy. Instead we should see a cautious series of small (25 basis point) increases, with careful evaluation as the rises take effect.
Since the previous meeting of the board in early February, the Bank has issued a quarterly Statement on Monetary Policy built around the realisation that Australia faces capacity constraints, that costs are rising and that interest rates will have to be raised because of the imminent increase in inflation. The Governor has campaigned on these themes in front of the House Economics Committee whose Chairman concluded even at half-time that the Committee had failed to dissuade the Governor from the path of raising interest rates. The Governor himself had said the Board’s only discretion concerns timing.
The RBA Governor went well beyond his normal brief to put the need for urgent economic reforms squarely in front of the government. The choice is stark: in the long-term, mediocrity with little further reform or a reasonable ability to compete in a fiercely competitive global economy if there is a package of radical and comprehensive reforms to increase the supply-side potential of the economy.
It is sad but true that in the immediate future nothing can be done to increase the supply-side of the economy. Within a few months, the supply-side could be freed up by announcing that the fiscal incentives to over-invest in real estate would be removed. But this is probably “politically impossible.” Bringing some retired workers back into the workplace could help a bit, but – again sadly – this seems more likely to be the result of the stick of “welfare reform” rather than the carrot of lower tax rates. It seems hard to raise the participation rate above 64% or lower the unemployment rate below 5% (see graph) without radical change.
A good deal later, there will be some relief from the construction of new ports and other investments now underway and the training or import of new skilled and unskilled labour.
Fiscal tightening is a theoretical option, but to do this now, for example by raising the rate of the goods and services tax, would be to risk political suicide. Sir Humphrey would commend it as “courageous”.
In the here-and-now, the only effective policy instrument is to raise interest rates. This is the job of the supposedly independent Reserve Bank board.
The Prime Minister has said that his election promise about interest rates was only that under the Coalition interest rates would be lower than they were under Labor in the late 1980s. He has also advised the nation, and therefore the Reserve Bank’s board, that in his view there is no call for any interest rate increases. He has consistently encouraged a dash for growth in this way, and so we have seen a long period of interest rates below neutral – in short, an easy monetary policy.
The only problem is that excessive periods of easy monetary policy - interest rates “below neutral” - have to be brought to a close with periods of tight monetary policy - rates “above neutral” – once capacity constraints have been hit.
In our first article in this series, in June 2002, we introduced a “Taylor rule” as one way of defining the appropriate setting of monetary policy. Our forward-looking Taylor Rule for Australia was: The cash rate = the inflation rate + the real interest rate + 0.5*(target unemployment – forecast unemployment) + 0.5*(target inflation – forecast inflation).
The witch’s brew in front of the RBA Board will be a cauldron comprising – at the bottom – an equilibrium real interest rate of 3.25% and an actual inflation rate of 2.6%, implying a neutral rate of 5.85%. If forward inflation were used (a touch over 3% given that “risks are on the upside”), the neutral rate becomes 6.25% or a little more.
But add to that gruel some gruesome seasoning: the continuing excess of domestic demand over potential supply of 1% over the next year and – worse still – an excess of inflation over the mid-point of the target of 1%. A “Taylor Rule” would be recommending an interest rate 1% higher than mere “neutral”. In other words, somewhere between 6.85% and 7.5% is entirely plausible as being in policymakers’ minds.
Let’s stir this steaming pot. Unless the Board were to disregard the future, the spell to be cast involves moving rates up toward 7%. Contrast this with today’s rate of 5.25% and one can only conclude that the likely decision to raise rates by 0.25 % tomorrow is only the first of several such increases.
Domestic demand in the Australian economy might of course slow to an acceptable extent well before cash rates reach 7 %. Indeed, the Prime Minister and the rest of the “no hike” school must believe the pressures lifting inflation will dissipate without policy action. The highly geared position of Australian households is manifest reason for caution in tightening monetary policy.
But in recognising the need for caution, we urge members of the “no hike” school to ask what happens if you are wrong. If demand keeps bubbling too strongly in the absence of rate hikes, and wages and inflation break out, there will be a painful slowdown imposed by far higher market rates at some stage. Far better to try to get ahead of the game and therefore (possibly) to head off this damaging scenario.