The RBA Unplugged
The RBA Board, meeting today, had better remember that it is important to stay on the road, even if it means not leading the race.
Global economic growth is now as strong as it gets, propelled by overheated China and booming America. Japan is in strong recovery mode. India is growing strongly and South-East Asia performing well. Even Euroland is growing, although with entrenched unemployment due largely to archaic labor laws.
The price of oil is high. This is largely a symptom of an inflationary global boom, although the Middle East has also injected a substantial risk premium. China has contributed to a marked lift of metals prices and, after the pause in May, upward price pressure on many commodities seems likely to reemerge.
US market interest rates have begun to rise. The initial jump was sharper than generally expected, leading to a temporary correction in both global equity and commodity prices. Official rate rises are now expected.
In Australia, the electorate has given a sophisticated response to a budget that one expert dubbed "the most inflationary since Whitlam." Voters overall praised the budget and especially the hand-outs for families. Those earning middle and higher incomes no doubt appreciated the cuts to their income taxes, and the Opposition's leadership promptly endorsed the cuts and promised also to deliver tax cuts for those on lower incomes.
But - and this is the sophisticated bit - the Coalition suffered a fall in popularity following the budget. The deteriorating situation in Iraq played a part. But I reckon that the electorate simply did not appreciate the cynicism of the big pre-election hand-outs.
Adding to the Reserve Bank's dilemma, Australia's domestic demand continues growing so strongly that domestic price inflation is well above the Reserve Bank's 2 - 3% target range. Even more worrying, our current account deficit is around 6 % of GDP, a level associated in the past with sharp falls in the value of the Australian dollar (see chart) and sharp increases in domestic interest rates. We have had a moderate fall in the value of the Aussie dollar from the recent peak of US 80 cents, but so far there has been no rout and domestic market interest rates have risen only moderately.
There have however been signs of an end to the house price bubble that has so worried the authorities, although the correction is probably nowhere as serious as the real estate touts are claiming. There is obviously some chance that falls in house prices will become large enough to adversely affect domestic demand, and this possibility is widely believed to be the main reason the Reserve Bank has not raised cash rates so far in 2004. There must be some such reason, as credit is running well above the rate that the Governor regards as safe, and he is (or should be) well aware of the risk of a loss of confidence if the current account deficit does not decline in the way predicted in official forecasts.
We had so far presumed that the Reserve Bank was effectively punting that a number of things would go its way - the terms of trade would stay high, global interest rates would rise only slowly, the currency would not collapse, credit growth would slow, and house prices would stabilize or only fall just enough to reduce domestic demand to a sustainable rate of growth. This scenario is the "immaculate slowdown".
Now, thanks to Ken Henry, the highly respected Treasury Secretary, there is another scenario to consider, the "dash for growth". Dr Henry sits on the Reserve Bank board, and only a year ago was supposedly arguing for cuts to official interest rates, for reasons that totally escaped this humble analyst at the time. Now, however, the analytic fog has cleared, thanks to Dr Henry's explanatory speech to Australia's business economists.
Highlighting how the budget "commits the policy strategy to the pursuit of faster GDP per capita growth" in the medium-term, Dr Henry has explained that "the pro-growth strategy asserts that the question that has to be asked is not whether we can afford to cut EMTRs (effective marginal tax rates and rates of withdrawal of welfare benefits), including the higher marginal tax rates, but whether we can afford not to." Otherwise the ageing of the Australian population will see rising taxes or cuts to government spending and lesser living standards.
It seems Dr Henry has adopted the supply-side tenets of "Reaganomics," especially the idea that cutting taxes on income will provide such a boost to economic growth that the tax cuts will pay for themselves in a reasonably short period. There is a view circulating in the economic underground that the Treasurer and his Secretary in fact wanted to cut taxes far more thoroughly and widely than occurred in the recent budget, but supposedly wiser heads ruled this out in favour of the large handouts that have been so cynically received.
Henry (Thornton) readily confesses to a strong, often reiterated, belief that cutting income taxes would create a strong additional source of growth for the Australian economy. It would do this by expanding supply more than by increasing demand. If Australians had received a decent set of tax cuts across all income levels (thereby directly addressing the strong disincentives to work and save currently afflicting people on welfare in particular), even Henry would be cheering Dr Henry's "dash for growth". He might even be persuaded that interest rates could be held down to allow extra growth without inflation.
But, sadly, the actual tax cuts in the budget are too small to act as an engine for non-inflationary growth. Their positive effect on supply will be swamped by the sizeable increases in handouts, which will boost demand. This net effect makes the "immaculate slowdown" far less likely. So, sadly, we have to conclude that the Reserve Bank is taking unnecessary risks with the Australian economy if it does not touch the brakes.
The start of June is the RBA's last chance to act before the speculation about the Federal election makes anything but a crisis-induced adjustment in rates difficult. While a rate hike may be seen by some as an act of political betrayal, Henry Thornton urges the RBA Board to raise interest rates immediately, by 50 basis points, to secure Australians' safety.