What’s wrong with relying too heavily on monetary policy?

Let me count the ways.

    • The way already receiving attention is the narrowness of the base of the action of monetary policy. Lots of households don’t get squeezed by monetary policy. A small number with interest income earn more. Lots of families pay more interest but a lot have paid off a fair bit of their mortgage and can extend their term or reduce the rate at which they’re paying off their loan early, so they don’t reduce their consumption. But the main burden is those with high debt. Monetary policy is sometimes called a ‘blunt’ instrument for this reason, but it’s really too sharp an instrument – that is it has too narrow a base. Fiscal contraction (spending cuts or tax increases) can be much more broadly based.
    • Monetary policy is a ‘blunt instrument’ in another sense – it has proverbially ‘long and variable lags’. Its effect on firms’ investment takes a good while to come through, is hard to predict and, can come on suddenly.
    • Tight monetary policy sees our exchange rate rise. You can argue that that’s pretty healthy in this climate in which we’re busting a gut to push resources into mining. But the risk is that we see disinvestment elsewhere in our traded sector reducing its contribution to export in the future. With current account deficits like ours, that may not be a good thing.

      All these problems were with us last time we were in a similar situation – which was the late 1980s. One can add the inflationary pressure and the pressure on wages. It seems to me there’s at least one further problem now.

      • High interest rates are depressing construction and, to my amazement, the heady prices being paid for residential property around the country are insufficient to attract sufficient resources into the sector.  Rents are rising strongly and will continue to do so – adding to inflation and to interest rates.

      We are living in interesting – and tricky times.

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        Chris Lloyd
        Chris Lloyd
        13 years ago

        It is drop-dead obvious to non-economists like me that interest rates are a blunt instrument. It is also obvious to anyone who followed politics for the past 20 years that it is an article of faith of the right that the only legitimate macro lever is the interest rate lever and then, only once the power to pull the lever is given to an independent authority like the central bank.

        The arguments against using the budget to mitigate the business cycle seem to be (i) the lags make it difficult to time the stimulus, (ii) governments cannot be trusted to use this power just look at how they pork barrel.

        It seems to me that argument (i) applies to interest rates as well. Knife edge lagged timing is not in itself a decisive argument for not using fiscal policy. As for (ii), this is trickier because the responsibility for fiscal policy cannot be given to an independent authority, else why have a government?

        If the issue is to force some discipline on government fiscal policy, then how about involving the central bank indirectly through their some kind of open assessment of how a governments fiscal record influences their interest rate decisions? I have in mind some kind of scorecard which allows informed commentators to calculate some kind of weight of pressure on interest rates from surpluses/deficits, perhaps broken down by different sectors of the economy. I am not sure exactly how this would be done, but I am sure the RBA is currently using econometric models that deliver quantitative weightings for interest rate decisions.

        So long as the scorecard remained fairly stable over time, and others could make the calculation, the RBA would not appear to be making inappropriate assessment of the government of the day. It would have been a terrific deterrent to the profligate spending we saw late last year. Just an idea…

        Andrew Norton
        Andrew Norton
        13 years ago

        The rising exchange rate is actually one of the ways monetary policy does its job – makes imports cheaper and encourages local producers to cut prices to compete.

        As Chris suggests, monetary policy is actually quick compared to fiscal policy and enables regular small try-it-and-see adjustments in an inherently uncertain situation. Fiscal policy is much slower. The government is in a panic about inflation but it will be many months before fiscal policy starts doing any significant work at all (other than the large surpluses that are a legacy of the previous government), by which time the indicators may be suggesting some other course of action.

        Monetary policy also has fewer down-the-track problems: no spending that will be politically difficult to stop, no increases in tax rates that governments will be tempted to keep (or, from the social democrat perspective, no tax cuts that will be hard to repeal). The RBA will just cut rates when there is no longer any need for them to be high.

        James Farrell
        James Farrell
        13 years ago

        The ‘exchange rate channel’ isn’t in the same category as the others: it reduces spending on domestic products, but but not spending per se. It merely switches the expenditure, which is essentially the same effect that the inflation would have had, if it had been allowed to occur, albeit at a lower cost in terms of social conflict. Fiscal tightening reduces consumption rather than net exports, and increases national saving, killing two birds with one stone. This is not to say that monetary policy shouldn’t be used, but two instruments are better than one if there is no conflict in objectives. I agree with Gittins that we’ll see this sentiment reflected in official pronouncements this year.

        Jc
        Jc
        13 years ago

        Whats wrong with relying too heavily on monetary policy?

        Nothing. Monerary policy is the only way to attain sound money and stable inerest rates. There is no link between sound money/ stable interest rates, budget surpluses and deficits. The time the US had the highest inflation levels was in the 70’s when the budget was basically square or just either side of balance. The deficit blew out in the 80’s yet interest rates and inflation continued to fall.

        The RBA’s long term objective should always be a flat yield curve and this ought to be the long term objietive imposed on the bank rather than using the CPI as it’s marker. It seems that we only achieve a flat yoeld curve when we’re moving from a tightening bias to the loosening bias.

        Is the government prepared to change its tax and expenditure policies more than once a year in some attempt to manage inflation?

        NPOV
        NPOV
        13 years ago

        Re the first concern – to what extent does the opposite apply once inflation is contained and the RBA is cutting interest rates? Or to rephrase – is the problem only temporary, therefore tolerable?

        We keep hearing about how the previous governemnt “ignored” warnings from the RBA – but were the RBA making actual noises about the need to use fiscal policy to attack inflation too?

        If the RBA could have put a case to the Howard government that bigger surpluses would prevent the need for interest rate rises that were likely to occur during an election year, would they have listened?

        Sinclair Davidson
        Sinclair Davidson
        13 years ago

        Lots of households dont get squeezed by monetary policy.

        Monetary policy doesn’t impact credit card rates?

        observa
        observa
        13 years ago

        “But the risk is that we see disinvestment elsewhere in our traded sector reducing its contribution to export in the future. With current account deficits like ours, that may not be a good thing.”

        “We are living in interesting – and tricky times.”

        We sure as hell are but I’ve got the bunker well stocked that’s for sure
        http://www.atimes.com/atimes/Global_Economy/JB09Dj01.html

        We have the spectre of Swan busily vacuuming up all the monopoly money the Reserve has ordered him to and as fast as they raise interest rates, the private banks are raising it faster because noone wants to lend to their dodgy customers any longer. The missus just received a ‘Changes to your NAB credit card account’ brochure, which to cut a long story short is changing the way they calculate interest charges, or more succinctly raising more interest collected without actually raising the rate. The important switch off bit for me was-
        ‘ If you pay your statement closing balance in full by the payment due date each month and continue to do so, this change will not impact you.’

        The rest of them are freaking doomed only fractionally more than yours truly and Co and our fearful cult leader Mogambo.

        NPOV
        NPOV
        13 years ago

        Sinclair, what percentage of households do you estimate have significant outstanding credit card debt?

        observa
        observa
        13 years ago

        Pssst! You lot know where there’s any more gold for sale?

        Sinclair Davidson
        Sinclair Davidson
        13 years ago

        I don’t know – but I suspect almost everyone has a credit card and uses it. I’m wondering why Nicholas (et al.) is only carrying on about mortgages and not credit card rates. I heard once (at the Economic Society conference in Perth 2001)that Australia’s ‘long and variable lags’ are much shorter than US ‘long and variable lags’ because of variable rate mortgages being popular here.

        I also suspect fiscal policy (actually not cutting taxes and hoarding the money) suffers from the same narrow base problem Nicholas says interest rate policy suffers from. Peter Costello told the 7.30 Report in August 2007 that 60% of families paid no net tax.

        Andrew Norton
        Andrew Norton
        13 years ago

        James – The higher exchange rate increases supply, of goods and services from overseas. On the conventional theory, inflation occurs when demand exceeds supply. Increasing supply therefore has anti-inflationary effects.

        Sinclair’s point is an interesting one. Credit card rates are at usury levels, but attract little political attention. Perhaps it is because people are seen as not using them to buy a necessity like housing, or because the absolute amounts of interest paid are lower.

        According to the stats on the RBA website, amounts accruing interest (about $30 billion) have dropped in three of the last four months, so perhaps rate rises are having an effect.

        conrad
        conrad
        13 years ago

        Jc: If you are worried about the number of meetings and how frequently a government is willing to change things, why not link policy to events? For example, you could have a policy that would (say) increase some level of tax if inflation rises above a certain level. This way you would get around having to sit and argue about raises in different political climates that are either not frequent enough or not conducive to good policy (e.g., election/pork-barrelling time).

        Helen
        13 years ago

        Couldn’t agree more.

        I’m not an economist, but I’d like to add: according to my observations, the cost of basic fresh foodstuffs (including wheat, therefore bread) has been pushed up by the drought, therefore no amount of rising interest rates is going to affect that, because it ain’t about demand. It’ll just mean that the couples in those marginal housing areas may manage to hang onto their mortgages while the quality of their kids diet declines.

        Andrew Norton
        Andrew Norton
        13 years ago

        Helen – Rising interest rates are not trying to squeeze out changes in relative prices between commodities, which are part of how market economies adjust. It is the overall level of prices, taking into account both those commodities going up and those going down. One of the bad things about inflation is that it introduces ‘noise’ into the price system.

        NPOV
        NPOV
        13 years ago

        Sinclair – are you saying that because many of the poorest families pay virtually no tax, then denying tax cuts to them hits them the hardest?

        Sinclair Davidson
        Sinclair Davidson
        13 years ago

        No. I’m not even sure what that actually means.

        I’m saying that just as “[l]ots of households dont get squeezed by monetary policy” similarly lots of households dont get squeezed by fiscal policy, i.e. increasing the tax take. I’m also suggesting that the “lots of households” argument itself may be too narrow due to credit cards.

        NPOV
        NPOV
        13 years ago

        But there’s been no suggestion that the government should increase the tax take as part of its fiscal policy, that I’m aware of. The discussion has been whether it should withhold promised tax cuts, or at least put them towards super by default (with an opt out facility). It’s hard to see why this would suffer a narrow base problem.

        It would be interesting to know how many households have little or no mortgage debt, but significant credit card debt. My observation has generally been that people either manage debt well or they don’t. I fully admit to being in the latter category, and the interest rate rises will definitely bite us – however being financially very comfortable, it won’t be a “squeeze” particularly – we will simply be forced to put less into savings. Which is I suppose another “unintended consequence” of raising interest rates.

        NPOV
        NPOV
        13 years ago

        (BTW, being unable to manage debt well and being financially very comfortabe are surprisingly compatible – providing you can keep on finding jobs with higher and higher salaries).

        Sinclair Davidson
        Sinclair Davidson
        13 years ago

        But theres been no suggestion that the government should increase the tax take as part of its fiscal policy, that Im aware of.

        Effectivily by cutting spending, and hoarding surpluses, the government is increasing the tax take.

        Jc
        Jc
        13 years ago

        Jc: If you are worried about the number of meetings and how frequently a government is willing to change things, why not link policy to events? For example, you could have a policy that would (say) increase some level of tax if inflation rises above a certain level. This way you would get around having to sit and argue about raises in different political climates that are either not frequent enough or not conducive to good policy (e.g., election/pork-barrelling time).

        Conrad:

        You could that but it’s really not optimum policy.

        Can we just think about this for a second? What you guys (those who support fiscal policy being used to fight inflation) are really arguing for is a defacto quantity of money theory. In other words have the Government raise of lower the amount of M3 or M4 circulating through the system. Instead of messing with tax rates etc. simply allow interest rates to float and have the RBA target the quantity of money through open operations – repos and reverse repos.

        Helen:

        Helen you my not be an economist but your onservation:

        Im not an economist, but Id like to add: according to my observations, the cost of basic fresh foodstuffs (including wheat, therefore bread) has been pushed up by the drought, therefore no amount of rising interest rates is going to affect that, because it aint about demand.

        is the most astute I’ve seen coming from a non-economist because it is right on the ball. You hit a home rune with that comment.

        Your observation is correct, a drought hitting our food supply is NOT nor should not be considered inflation, it is a change in relative prices. Its offer’s a signal to the market through the price mechanism to produce or import more.

        And yes, it is also dis-inflationary if income is relatively constant and more disposable income has to go to satisfy that need. So putting up rates in the face of that event would be pure folly. However that’s what you have targeting the CPI.

        NPOV
        NPOV
        13 years ago

        Sinclair, but the spending cuts are targetted – they’re not cutting spending to services like health and education that poorer families are more dependent on.
        OTOH, I agree that if the savings achieved by the spending cuts were redistributed equally (everyone got exactly the same amount) poorer families would benefit. But nobody was seriously proposing that either, that I’m aware of.

        JC, is it really true that the RBA doesn’t take external factors like drought and oil demand/supply imbalances that are driving much of the recent CPI increase into account?

        AIUI, in the US, the Fed targets “core inflation” that leaves out food & energy.

        Jc
        Jc
        13 years ago

        Nic:

        Messing with fiscal policy to somehow act as an inflation weapon means you either have to raise taxes or lower spending.

        1. Raising taxes doesn’t hit lower income levels as they would be unlikely to be hit with a tax hike and they pay very little tax.

        2. I really can’t see anyone here proposing that we institute real spending cuts.

        So, what you are arguing for is lowering the propensity to save by raising taxes on the savers. Lowering the savings rate eventually leads to a reduction in living staandards through a fall in the capital/ labor ratio.

        Sinclair Davidson
        Sinclair Davidson
        13 years ago

        The point about credit cards is empirical. You claim that monetary policy won’t work well because not all households have a mortgage, or they may have a small mortgage. That is a plausible argument. But all (most) households have credit cards. I imagine the rates on those cards will go up as well (not as much as mortgages – as you indicate). How do you know that monetary policy isn’t working, or won’t work, through credit cards? I don’t know what the answer is, but I’m sure you don’t either.

        I’m arguing here about churning.

        Picking up on the net tax neutrality and your analogy – in order to be effective I would have thought that fiscal policy – to be effective – would have to move people out of the red and into the black.

        Jc
        Jc
        13 years ago

        NPOV:

        JC, is it really true that the RBA doesnt take external factors like drought and oil demand/supply imbalances that are driving much of the recent CPI increase into account?

        True. The RBA does its best to arrive at core inflation and tries strips out the influence of relative prices.

        However I would argue that it becomes next to impossible to strip out the higher cost of energy impacting the CPI as it will leach into all consumer prices even services- the effect on say fees charged on increased cost of plane travel or car travel to meet a client as a quick example. The relative inelasticity effect of energy on the CPI and its dis-inflationary impact make the CPI a difficult marker for use as inflation measure as the RBA could be raising rates at the wrong time.

        Wrong Time? Our yield curve is negative at the moment implying a slow down or the RBA acting too tight. They could very well be over egging reasons for the tightening.

        Sinclair Davidson
        Sinclair Davidson
        13 years ago

        The leverage monetary policy has to increase or reduce peoples credit card payment is roughly an order of magnitude lower than it is with their household debt.

        You have made the claim that monetary policy is blunt because it has a narrow base and you talk about mortgages. But credit card debt is more broadly spread across the economy and monetary policy may have the desired effect there. This is an empirical question – I don’t know the answer. Neither do you, but I would think that you should look into it. (At least get the government to pay you to look into it.)

        Since we last spoke I found this at The Age

        What’s more, credit card rates are going through the roof. Yet the big banks have been lifting credit rates at twice the pace of RBA guidelines.

        Last month NAB lifted its credit card rates 0.5 of a percentage point. And if you are unlucky enough to have the “low rate” GE Mastercard, its rate jumped one percentage point at Christmas.

        I don’t know about pumpernickel – having tasted it once I’m sure it is a health hazard :)

        NPOV
        NPOV
        13 years ago

        http://www.abs.gov.au/AUSSTATS/abs@.nsf/Previousproducts/968DA9850C931BE6CA2570EC000B715F?opendocument

        In 2002, 35.6% of households were paying regular interest on their credit cards. The average payment per week was $65.

        NPOV
        NPOV
        13 years ago

        Sorry, make that 1999. So not all that useful.

        Jc
        Jc
        13 years ago

        JC – both your comments seem wrong to me.

        1) Its true that those living on benefits wouldnt be hit by tax hikes. But low wage workers pay a fair bit of tax (and then have a good deal of it returned in family payments.)

        lower earners hardly pay any income tax, even so they wouldn’t be the people most effected by tax increases as I couldn’t imagine any government raising their taxs or reducing their benefits especially during a time of visible plenty.

        ) Id love to see lower spending. There are plenty of places to look.

        The finance minister just annouced $600 million of “savings”. It’s miniscule. Add up all the additional spending they promised and it all smokes and mirrors.

        As I said , Nic, if the objective it take money out of the system to prevent inflation, the best thing to do would be to target the quantity of money by the changing the RBA’s ambit.

        observa
        observa
        13 years ago

        I’d be cautious about the no. of credit cards paying interest. My wife carries a Visa card which is paid off at the end of the month. However I carry a business Mastercard which charges interest immediately on any purchases with interest debited at the end of the month. That keeps the card holding fee at $35/yr and I keep it in positive balance quite easily via EFT and consequently pay no interest. However it would be counted as interest bearing for stats. Furthermore it’s totally for business, rather than personal debt. Lots of business people use credit cards the same way nowadays, yet they must be held by an individual. A company cannot hold a credit card. As a result, companies often reimburse employees personal credit card accounts that are business deductible expenses.

        observa
        observa
        13 years ago

        And judging by the actions of the US Fed now, it’s totally academic what our Reserve does now. I’m with the Guru- We’re all freaking doomed financially. You can’t throw money at a solvency crisis caused by throwing too much of it at any downturn or economic threat previously, over a long period.

        Jc
        Jc
        13 years ago

        And judging by the actions of the US Fed now, its totally academic what our Reserve does now.

        No, not really it isn’t academic. The US yield curve has turned positive and further Fed loosening will turn it into a relatively steep yield curve. Id be very wary of talking down the US economy further than the expectations of a mild recession. Every single major news publication, pundit, academic, stock trader and market economist are talking down the US economy predicting a very bad outcome. This makes me think that the stock market has pretty much discounted the worst of it. Lower rates, positive yield curve, almost unanimous negative expectations means that the market has fully discounted all the bad things and worse which makes the US market very compelling against others… especially financial stocks.
        You can buy brand names, Citigroup, Morgan Stanley… etc. at big discounts in the market that has mostly fully discounted the worst and an obliging, panicked Fed. This is where you make a lot of money.
        Look at our yield curve, negative and the RBA hasn’t even begun to think of easing, which means they need a large financial accident for us to reach a riot point where the RBA will ease. I think the best bet going is buying top US financials and shorting Australian regional banks fully hedged. The RBS seems to need a financial accident to cause a riot point to forced them to reassess.

        observa
        observa
        13 years ago

        JC, Mogambo puts the biggest world economy’s debt problems into something we can all comprehend, except that we don’t want to comprehend it yet. US official interest rates are now below inflation which means you won’t need an economics degree to work out borrowing to pay it back with funny money makes sound 1970s sense again, providing lenders don’t cotton on equally as fast. Ipso facto, either we’re headed for a massive recession or double digit inflation to wash all this monopoly money creation away again. It’s beyond the control of central bankers or govts now.

        observa
        observa
        13 years ago