Moving monetary policy around – why the 0.25%?

I’ve never understood central bank’s recent penchant for small changes in monetary policy – these days 0.25% per month. The idea is that the facts emerge slowly, economies respond to monetary policy slowly (with long and variable lags) so our changes should be slow too. But that doesn’t make any sense. These things can be said about the Titanic heading towards the iceberg. The Titanic was a large ship – 46,328 tons to be precise – it turned slowly, and the iceberg would have made itself out to the guys watching out for them slowly as they scanned the dark horizon. But once they decided to turn the rudder, they didn’t say “wait a bit, the Titanic only turns slowly so lets turn it in notches”.

The same basic principles apply to monetary policy. One is in a situation of considerable uncertainty, and in ‘normal’ times one might hope that adjustments to the monetary rudder might take place by the odd 0.25% movement. But in the last few months it’s become clear the expectations of inflation in the immediate future have ratcheted up by a percent or so.

Now one might take the view that it’s premature to raise rates, that the credit crunch is so serious that it will do a lot of the work for us. But that’s not the attitude the Bank took. And if that’s the case, it seems pretty likely that 25 basis points won’t do it. One can argue that real interest rates have fallen since the election. If you’re of that mind, it seems to me it would have made more sense to increase rates by more than 25 basis points last time – perhaps by 50 or 75 basis points.

I remember last time I argued this was when interest rates were at their height in early 1990. It seemed to me obvious that they should be reduced fairly quickly once it was clear they’d substantially slowed the economy. In fact reducing them was a long drawn out affair as this graph shows.

30 Jul 1993 -0.50 4.75
23 Mar 1993 -0.50 5.25
8 Jul 1992 -0.75 5.75
6 May 1992 -1.00 6.50
8 Jan 1992 -1.00 7.50
6 Nov 1991 -1.00 8.50
3 Sep 1991 -1.00 9.50
16 May 1991 -1.00 10.50
4 Apr 1991 -0.50 11.50
18 Dec 1990 -1.00 12.00
15 Oct 1990 -1.00 13.00
2 Aug 1990 -1.00 14.00
4 Apr 1990 -1.00 to -1.50 15.00 to 15.50
15 Feb 1990 -0.50 16.50 to 17.00
23 Jan 1990 -0.50 to -1.00 17.00 to 17.50

As you can see from the table, 100 basis point changes were the fashion back then.

I’m not holding myself out as knowing more than the RBA or anyone else about what the fundamentals of monetary policy should be here. I don’t envy them their task. But if I was thinking what I think the RBA is thinking, I don’t know why the last increase was just 0.25% – with talk of following it up with another one the next month. What would have been wrong with 0.5%?

Postscript: The Bank did consider a 50 basis point rise and decided against it, for reasons that look quite reasonable to me.

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Tim
Tim
13 years ago

well given the sorts of things they’ve been saying lately, it seems like they might be trying scare the economy into slowing down so they don’t have to raise rates at all. Now that would be a novel approach.

Ingolf Eide
Ingolf Eide(@ingolf)
13 years ago

With what’s happening to base rates elsewhere, raising rates at all is pretty aggressive, particularly in such an unsettled credit environment.

I’d imagine the RB is pretty damn nervous about what they’re doing and that despite their public stance, Tim’s take may be close to the truth.

Patrick
Patrick
13 years ago

I agree with what (I think) Tim is saying – that they are a bit scared that the economy is already slowing and they don’t want to throw out the anchor!

But NG will be pleased to know that I’ve heard more than one financial institution financial officer say much the same thing about 25 basis point rises.

Mark Picton
Mark Picton
13 years ago

Scaring the economy into slowing down so they don’t have to raise rates at all is not really a novel approach at all. Reducing inflation becomes extremely costly in the presence of high inflationary expectations. Interest rates have to remain higher for longer. If the RBA is credible, it can prevent persistent inflationary expectations from emerging. In other words, if the markets believe that the RBA will do whatever it takes to get inflation back in the desired zone the Bank will not have to raise interest rates so much to do it.

Vee
Vee
13 years ago

I asked myself the same thing over at Peter Martin’s. However I believe “Henry Thornton” has been arguing the same thing for quite some time.

Fred Argy
Fred Argy
13 years ago

I understand your viewpoint, Nicholas, but I argued the opposite on the eve of the last interest rate rise. In a letter published in the AFR I said the following.

Since the early 90s, the RBA has a marvelous record and has shown excellent judgment in periods of uncertainty like the present one. So it is presumptuous to offer advice but here are three reasons why the RBA should NOT raise interest rates on Tuesday and wait two or three months to decide:

* credit market are still brittle, with the risk spread between the official cash rate and the rate on Australian prime residential mortgage-backed securities at 75 to 80 points compared with a normal spread of 30 to 40 basis points;

* the economy will gradually slow down of its own accord because of the wealth effect, the effects of the world economic slow-down, an over-valued exchange rate (reflecting large interest rate differentials), the effects of the promised fiscal tightening in 2008/9 and the delayed effect of earlier interest rate increases (monetary policy takes about a year to impact fully on the economy and we have had three official interest rate rises in the last six months or so plus an unofficial one by financial institutions);

* many of the inflationary forces in the economy are of the cost-push variety (oil, utility prices, food etc.) which dampen demand but do not respond much to domestic monetary policy; while a rise in interest rates will reduce the risk of a wage-price cycle, that risk is really quite small in todays deregulated labour market (even allowing for the proposed Rudd Government changes);

End of quote. Just goes to prove what Bernard Shaw said about economists.

NPOV
NPOV
13 years ago

From http://www.theaustralian.news.com.au/story/0,25197,23239168-12377,00.html;

“The discussion noted that a good case could be made for the larger move, on the grounds that the inflation outlook had deteriorated and the risk of inflation expectations becoming dislodged had increased.

“Thus there was a case for the board to send a stronger signal of its intention to act as necessary to reduce inflation.”

Some sympathy for borrowers

But the central bank decided against such a move after it noted the level of interest rates already faced by borrowers.

Fred Argy
Fred Argy
13 years ago

Sorry Nicholas. I read your piece quickly and thought you were advocating a 0.5% increase in preference to the more gradual 0.25%. It appears you were not. I think the RBA has the same concerns as I have, so 0.25% was seen as a good halfway house.

And I agree with Mark and other bloggers that by stressing its tightening bias, the Bank is trying to scare everyone. But moral suasion is a two edged sword. It can deflate inflationary expectations (which is good) but raise bond market yields (bad because it can then force the Bank to respond by raising interest rates more than it really wants: let’s face it the Bank is influenced by markets as much as the other way around).

Tom N.
Tom N.
13 years ago

THE ACADEMIC POSE vs THE PLAIN ENGLISH PROSE

I don’t mind (much) how quickly they raise interest rates, but I do wish that they would raise them by a quarter of a percent, rather than by 25 basis points, if that’s the increase they choose. Use of the term “basis points” in general public discourse is just pretentious wanking intended to impress, well, non-economists; much as socioligsts insist on “biparating” things, rather than splitting them. Now, I don’t mind if economists want to out(basis)point each other, as long as its done in the privacy of their own homes or orrifices. But, pleeease, spare the punters from this crap.

sdfc
sdfc
13 years ago

Tim, the problem with the Bank threatening to raise rates and then not doing it would leave them with a credibility problem, so I would take the Bank’s threats very seriously.

The time for a 50 point increase(s) was 2006. If they had been more aggressive earlier they might not be in this predicament.