Henry's advice for the RBA Board meeting on 2 December 2003 is to tighten and explain why, accepting full responsibility and accountability for its action. Stand back and watch the political fireworks!
Congratulations to RBA Governor Ian Macfarlane, for finally biting the bullet on monetary policy. Policy has been too loose for too long, but his first move to restore an appropriate monetary policy is welcome nevertheless.
He will need at least two further 25bp rate hikes (or one of 50bp) to restore a broadly "neutral" monetary policy, ideally with one tomorrow. Indeed, we believe he needs to go further in the New Year, to engineer a positively tight monetary policy.
As importantly, while it tightens further, the Reserve Bank needs to explain better what it is doing. The Bank is now formally independent of political government and has the power to set interest rates. However, many in government believe the Bank does not fully accept the accountability that goes with this power. Specifically, many in government feel that the Governor's explanations for the rate rise have been inadequate. While the RBA has the power, the Treasurer is left to explain why rates have risen and will rise further.
This month we outline how the Bank should explain why interest rates have to rise further. No doubt it will be able to craft a more polished and complete account, but we believe our outline will provide a useful framework.
So far the RBA has concentrated on explaining that inflation, while under control now and likely to go lower, will at some future time be likely to move above the target range, when the exchange rate stops rising. The Governor says himself that forecasts are unreliable, which leaves any objective observer asking of rate rises "why now?" and "how much?" No doubt the Treasurer and the Prime Minister, like the markets and the media, are asking themselves the same questions.
The Bank did give an immediate one-page explanation when it tightened in November. This was followed by a 48-page quarterly statement on monetary policy. Some people may simply have not wanted to understand, but the ensuing confusion seems due in part to the RBA not emphasising that the tightening is as much about maintaining financial system stability as about achieving the inflation target.
Since words have not resonated, a simple graphic image may help. Especially one that can draw out the clear distinction between what lies ahead and some of the policy mistakes in Australia's past.
Take this instructive chart which compares the "neutral" cash rate and where the cash rate has actually been set:
A "neutral" cash rate is defined as the past 12-months of inflation plus the normal real (inflation adjusted) bond yield, here proxied by the yield on indexed bonds.
It shows that for more than 15 years the cash rate has usually been set very close to "neutral". When the actual rate is above "neutral", monetary policy is tight; when it is below, policy is easy. Since the mid-1980s, there have only been three episodes when the cash rate has departed significantly from "neutral" for an extended period.
The first, and most damaging, was in the late-1980s, when the monetary tightening caused "the recession we had to have" and shook the financial system severely. There were reasons at the time, but hindsight does not view this use of policy discretion favourably. The second was a significant victory, in 1995 and 1996, when the Reserve Bank did not follow the "neutral" rate higher, but held its ground, confident that the "neutral" rate would fall in due course.
But it is the third episode, since the start of 2001, that has brought us to the current dilemma. The actual rate has been held well below the "neutral" rate, stimulating the Australian appetite for debt and speculation, for so long that there is now a threat to financial system stability if it continues. This is the vital point. Maintaining stability of the financial system is as important a responsibility of the RBA as controlling inflation. And the main consequence of easy money since 2001 has been the excessive growth of credit and the associated explosion of household debt. Together with the resulting powerful rise in house prices, unsustainable growth of household demand and the blowout of the current account deficit, these developments are a threat to financial stability.
We suggest the RBA Governor table this graph with his opening statement to the House of Representatives Standing Committee on Economics, Finance and Public Administration in Brisbane next Monday. He can then make the case crystal clear, that a series of rate rises is in prospect, first to withdraw the present level of stimulus in the monetary stance and subsequently to actually impose some restraint on excessive domestic demand growth. But at the same time he can take away the fear that there will be a repetition of the mistake made in the late-1980s.
He must explain that he is acting to protect the stability of Australia's financial system. And, as he has already done, he must also warn that, once the current rise in the A$ has run its course, the pace of domestic (non-tradeable) inflation (currently 4% pa) will dominate the headline inflation rate. Of course he should say there is some uncertainty: for instance, if the global recovery continues at its current stronger-than-expected pace, we must expect additional upward pressure on interest rates.
The truth will hurt, unavoidably. The Governor can hardly avoid saying that how much additional restraint will be required will also depend on the way Canberra itself pulls its own policy levers. If fiscal policy is conducted responsibly, perhaps the RBA need only hike rates an additional ½ - 1% over the "neutral" rate, implying a cash rate of 6 - 6½% at the peak of the current tightening.
But if there is the usual pre-election looting of the Budget surplus, the increase in interest rates through 2004 and into 2005 will have to be greater. The signs are ominous, with spending already promised to secure passage of Medicare and education reforms and fiscal drag likely to be returned in the form of tax cuts.
The government knows the independent RBA has to, and will, act, and it will criticise the Bank from the sidelines to grab whatever political advantage there is to be gained. Life will always be tough for an independent central bank properly discharging its duties.