Future moves on interest rates

A recent version of the Taylor rule specifies that the Federal interest rate target should have a threefold aim: (a) to curb inflation (b) to avoid excess unemployment and (c) stop prospective asset prices.

With a rising Australian dollar (and with an under-utilised labour market), there is little prospect of inflation, at least for the next year or so. If anything, underlying inflation seems likely to range around 2%.

It is widely forecast that Australia will continue to have at least 1.5% to 2.5% of excess unemployment and under-employment over the next twelve months.

A rise in interest rate will do nothing to relieve housing prices, as it only hits demand and does nothing for capacity. It is more likely to have a significant effect on share prices but these are still well below their peak level of December 2007.

So why is the RBA tipped to put up interest rates by as much as 1 percent over the next 12 months?

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15 Responses to Future moves on interest rates

  1. Jacques Chester says:

    OK, I’ll play the prognostication game.

    First, the RBA are fairly conservative.

    Second, house prices have basically gone totally nuts due to low interest rates. That’s a brand new bubble they want to pop before too many people are tied up in it.

    Remember that the GFC was in large part caused by the US Federal Reserve’s gangbusters inflation of the US housing market.

  2. Fred Argy says:

    Yes, Jacques, the RBA is very conservative – but they must have a good reason for their action.

    House prices have risen a bit, but they will be wound back, with declining population, less stimulus and the recent interest rate appreciation.

    In any case, I don’t know what interest rates will do to increase capacity.

  3. I think the RBA was right to increase rates, and right to put them up more in the near future. Indeed, I think they probably cut them a little too much (25 or 50 basis points) but that wasn’t a big problem. Generally speaking, I think their judgement has been as good as you can hope for in terms of managing a government currency.

    I don’t believe that monetary policy should be used to target employment or economic growth. While those are often useful intermediary indicators, they are not the goal. While the monetary illusion is very real, it cannot create a sustained improvement in the real economy… and so is a useless tool for generating sustainable growth & employment.

    In contrast to the Keynesian approach (of using money illusion to their benefit) I suggest that the RBA should have only one goal — and that is to decrease the amount of money illusion in the economy by keeping the ratio of broad money to production roughly constant.

    If that is their goal, then I think their current policy is appropriate. When the GFC hit there was an increase in perceived risk, which means a drop in the expected return from investments, which led banks to decrease their lending, which amounts to a drop in the credit multiplier. As the credit multiplier is an element in broad money supply, broad money supply had dropped. Therefore it was appropriate for the RBA to drop rates (increase base money supply) to ensure a constant broad money: production ratio.

    I think they over-estimated the drop in the credit multiplier (as I think most people over-estimated how much the GFC would impact Australia) and so I think they cut rates a little too much… but that’s a minor quibble.

    As private investment rebounds the credit multiplier is heading back up… and if the RBA doesn’t consequently adjust the base money supply back down (by increasing interest rates) then we will start to build inflation back into the system.

    (By inflation, I include both consumer good inflation and asset price inflation, though I think CPI is a good enough proxy in Australia unless somebody can point me towards some distorted incentives that are encouraging excessive demand for an asset class.)

  4. Tel_ says:

    Investment from overseas, leads to rising asset prices, RBA reacts with higher interest rates, which is attractive to overseas investors, encouraging them to invest.

    I presume the RBA would be aware of this positive feedback loop, a little bit of this activity could be a good thing for Australia right now… foreign investment might encourage job creation, but rising interest rates would be a problem for existing businesses. It’s a bit of a seat-of-the-pants judgement to figure out where the balance is.

    House prices have risen a bit, but they will be wound back, with declining population, less stimulus and the recent interest rate appreciation.

    Declining population?

  5. derrida derider says:

    The RBA has learnt from the rapid over-tightening of monetary policy in 1989-90 that precipitated the 1990-91 recession. What they haven’t learnt – indeed haven’t ever acknowledged – was that their failure to keep rates low enough for long enough during the recovery locked us into a totally unnecessary high rate of unemployment for a full decade. It is the duration, rather than intensity, of aggregate demand insufficiency that leads to the long overhang in labour markets – a shallow U-shaped recession casts a longer shadow than a deeper V-shaped one.

    They show every sign of repeating this mistake.

    Really, I can’t follow their reasoning. They talk about “normal” and “emergency” interest rates. But the long run normal real interest rate for capitalism is about the population growth rate (as Solow-Swan implies) – that is, about 2.5-3%. Given that the strong dollar and weak labour market is gonna hold inflation down to under 1% next year that makes the “normal” rate 3.5-4%. But with no inflation and some insufficient demand, current rates should be below this. Where they are now is not, therefore, in any way an “emergency” setting.

    Then you have to think about sectoral effects. With the dollar nearing parity with the US dollar due mainly to the expectations the RBA has created of high interest rate returns in Oz, the farmers, miners and manufacturers will all suffer greatly.

    Clearly they think they are in a pre-October 2008 economy. They’re not.

  6. derrida derider says:

    John Humphreys, its a long time since I saw any serious economists put forward the classic monetarist position. Do you really think the velocity of money is roughly constant? And do you really think the definition of broad money is wide enough to avoid Goodhart’s Law?

  7. Fred Argy says:

    Sorry, Tel, I meant to say declining rate of population growth (a result of government recent action).

    I agree with you, DD.

  8. Tel_ says:

    With the dollar nearing parity with the US dollar due mainly to the expectations the RBA has created of high interest rate returns in Oz, the farmers, miners and manufacturers will all suffer greatly.

    The US dollar is going its own way (down mostly) for it own reasons, and the RBA shouldn’t slavishly try to follow it. We are part of a bigger world.

    If you look at 5 years of Aus dollar vs Euro, the sudden bashing at the end of 2008 and start of 2009 has cleaned itself up and we are running pretty much level again. Presuming we do stay around about the 0.60 Euro point, give or take a little, the Aus dollar sits where it did 5 years ago.

    Against the Brazilian Real we have stayed reasonably steady for the last 3 or 4 years. Against the Japanese Yen we are back where we were 5 years ago having been both up and down. I think we are sitting about right where we are, I agree that there is no good reason for further Aus dollar increase, stability should be the aim.

  9. Strange question DD… I don’t think the velocity remains perfectly constant, but that was not relevant to my previous comments.

    And as broad money is not the target variable, goodhart isn’t going to hurt it. I accept that CPI is an imperfect measure, but I don’t think it is a useless measure.

    I share your bafflement, but for a different reason. Keynesian macro-economics has been discredited so many times it’s become a sport… and yet the financial journalists and arm-chair commentators seem fixated on it. In contrast, the whole idea of inflation targeting and central bank independence (the updated monetarist position) is conventional wisdom in theory, but nearly nobody talks about it.

    The world has gone mad. Thankfully, the RBA hasn’t followed it.

  10. Butterfield, Bloomfield & Bishop says:

    John, given there are sooo many examples could you give us one?

  11. Examples of what? If you want an example of Keynesian analysis in the media, just pick up any paper on any day.

    If you’re talking about examples of Keynesian economics being discredited, consider the Philips curve. Monetary illusion is temporary, but MV = PY is permanent.

  12. Butterfield, Bloomfield & Bishop says:

    right John you have none.

    The Phillips curve argument either means you have never reads Keynes or you choose to mislead what he said.

  13. derrida derider says:

    Ah, John, you forget its MVPY. True by definition, but you have to ask yourself what drives V as well as M. Hence my first question. And empirically Goodhart certainly has dogged all previous attempts at fixing M (aren’t markets wonderful in subverting attempts to make people do what they don’t want to do?).

    BB&B didn’t say it well, but its true you won’t find a Phillips curve in Keynes. Remember it was a purely empiric construct that was only fitted into a Keynesian theoretical framework after it was discovered, not the other way around. The empiric relationship broke down in the 70s (mainly because of Goodhart’s Law, ironically enough – the Lucas critique is really just a generalisation of that shrewd insight). But this does not permanently invalidate the whole Keynesian project, not least because there is evidence the curve still holds empirically in certain circumstances. Such as a deflationary spiral – precisely what was feared in late 2008.

  14. Butterfield, Bloomfield & Bishop says:

    Actually DD Velocity dives likes a bullet in a depression making increases in the monetary base problematic.
    Ironically research showing how unstable the velocity of money is came out just as monetarism was being heralded as the best economic policy.

    Keynes actually stated you only use fiscal policy when monetary policy is made impotent ie the liquidity trap. how ironic John is heralding monetarism when we see the liquidity trap in action.

    If monetary policy is working then Keynes would use monetary policy and fiscal policy would only be a medium term tool.

  15. DD — I was talking about “broad money”, within which I include velocity. In the long run, velocity is fairly stable, in the short-run it acts much like the credit multiplier. Either way, my preferred goal is to keep the ratio of broad money to production stable.

    And as I said, I’m not trying to target any particularly level of M… so Goodhart is no threat to me. By all means, stop measuring it.

    Keynesian economics is not about what Keynes wrote. Indeed, many post-Keynesians will insist that mainstream Keynesians are a bunch of fools. But mainstream Keynesian is what is commonly believed, and what is wrong.

    The Phillips curve doesn’t hold in the long run because MV=PY. It does hold in the short run because of monetary illusion (which I mentioned in my original comment). But any possible short-term gain (likely small) leads to long term pain.

    Consequently, I think the RBA was right to concentrate on ensuring no long term pain.

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