A slow down in Australia’s economic growth?

I find little evidence of any RBA remorse or regret for what it has done to our economy. Although contributing to a very low GDP growth, a shocking malaise in the housing, retail and low-leverage business credit and rises in unemployment, the RBA remains almost complacent. Nor is it too worried that our terms of trade are moving against us. It is all for a good cause lower inflation.

Along with many others, I have been a persistent backer (going back as far as January 2008) of a “softer” line on interest rates. We now have Bernie Fraser’s view that the two most recent interest rate increases (in February and March) were both unnecessary. It also took the RBA too long to act when it did. It has now delivered a small interest rate decline of 0.25%., with the likely prospect of more to come but, as the Australian suggests, the real reason the RBA did not cut interest rates in August was to save face. The RBAs own self-esteem and amour-propre would now inevitably stand in the way of moving too swiftly towards a more stimulatory stance.

However, the bigger failure of the RBA is not that it is a slow-starter but that its whole economic analysis could be based on a furphy.

It is arguable that its analysis may have been based on several misjudgements:

1. First, the Bank is responding to imperfect inflationary incentives. Most of the short run inflationary forces are based on oil, energy and food which form part of the core values – and are driven by real rather than monetary factors. First, by focusing on core values, it ignores the indirect effects on many of the relevant components of inflation. It also ignores the underlying forces, such as slowing economic growth on demand and supply-side effects, which come into play to correct the problem. And it highlights the fear of passing short-run price indicators, instead of anchoring on long-run inflationary expectations which are dependent on less volatile forces.

What we need is to define core inflation by decomposing headline inflation into permanent and transitory components, and identify core inflation as the permanent component. We dont really have any specific indicator of this kind at present.

2. Secondly, interest rates act as a delayed action weapon: they take a long time to work and are usually very unpredictable. Treasury looked at all the evidence and decided that: a 1% rise in short term rates cuts economic growth by 1/3 of a percentage point in the first year, another third in the second year and a sixth in the third year after it was made.

3. Thirdly, it is not the price of money but its availability the unwillingness of lending institutions to lend to each other. So monetary policy, which relied solely on the price of money, could not inject much economic stimulus at present. It requires a much wider agenda (of the kind adopted by the Federal Reserve Bank).

The Fannie and Freddie intervention is fine: it will boost housing finance and shut off one very big source of debt inflation in the USA. But what will this do to the large and high-leveraged corporations and small borrowers?

4. We now have a decentralised, non-unionised labour market and very elastic supply of labour from overseas. So the risk of wage-price cycle is really small, especially in the developing employment market.

In addition, fiscal policy is still excessively tight. I believe fiscal and monetary policy need to move in synchrony not in opposite directions, as some of our leaned pundits seemed to argue.

It is interesting to draw comparisons with the US experience. Despite the risk of a falling US dollar, it allowed big falls in the interest rates and encouraged strong direct fiscal interventions. And it is persisting with its expansionary viewpoint. Bernanke, the Governor of the Federal Reserve Bank, is consistently warning that (a) the recent decline in commodity prices and increased stability of the exchange rate should lead to lower inflation (b) that the financial storm has not yet subsided and (c) that more fiscal and monetary action may be needed. For now, at least, it is expecting positive results for the American economy from such an expansionist policy – relative to the European inflation-first policy.

A similar course is now open to Australia. What we need is (a) a more interventionist, innovative monetary policy and (b) a more active fiscal policy. To simply persist with cautious monetary policy and tight fiscal policy would now be irresponsible. (Why, incidentally, is the NSW Government so worried about running a small budget deficit of 1 billion dollars – at a time of expected property recession and when strong contra-cyclical action is clearly needed? Thats crazy too.)

====

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pedro
pedro
13 years ago

I suppose it is easy to be critical after the fact, but I seem to recall that the majority expectation (including from the govt) earlier in the year was that the rate rises were necessary. Definitely some were arguing that the inflation was coming from overseas and thus could not be tamed with interest rate rises, but Chris Richardson and many other commentators wanted the tax cuts cancelled on top of the rate rises.

I also have some sympathy with the RBA because, despite what you say about decentralised wage fixing, the government had just changed and the future of the industrial relations system was, and remains, uncertain and the unions started demanding a payoff for their investment in the Rudd government.

JC
JC
13 years ago

Welcome back Fred. Hope you’re 110%.

What we need is to define core inflation by decomposing headline inflation into permanent and transitory components, and identify core inflation as the permanent component. We dont really have any specific indicator of this kind at present.

Why not simply firm up an agreed annual money supply growth M1 and let the market decide interest rate levels?

We now have a decentralised, non-unionised labour market and very elastic supply of labour from overseas. So the risk of wage-price cycle is really small, especially in the developing employment market.

demand/supply for labor labor is still responsive to price and doesn’t mean wages growth won’t respond to inflationary forces :see the non-unionized building sector for an example.

observa
observa
13 years ago

Well it’s like this, as Gerry Jackson points out so regularly and something which our economic and media punditry have been totally blind to-
“From March 1996 to December 2007 currency rose by 110 per cent, bank deposits by 178 per cent and M1 by 163 per cent.” (Monetary Aggregates – D3 Reserve Bank).
Now if we take the high side of that magical 2-3% inflation target that our Reserve so constantly tells us it is apparently deliberately targetting, that means prices should have risen 38.4% (3% compounding over 11 years) Now look at those money supply figures straight from the horse’s own mouth. What on earth did the Reserve expect would happen with all that monopoly money eventually? Ditto with the US Fed and so many more central banks around the globe. We might like to recall those negative real interest rates back in 2001 in the US and typically low interest rates around the globe.(Japan for God’s sake?) Was this the real underlying ‘natural rate of interest?’ Not bloody likely folks!

Why didn’t all that money creation go straight into price inflation? Well it would have if you threw it at a young demographic like in the late 60s and early 70s. However, our profligate pinstripe Keynesians overlooked some important structural changes this time round. An aging baby boomer demographic was thinking about the lure of the grey nomad trail at precisely the same time as Asian savers, chastened by an Asian meltdown, decided they didn’t want to be in that position again. As the West’s BBers began to invest in shares and RE, Asians worked harder and saved harder (often forcibly due to govt financial and exchange controls). Low interest rates means gear yourself for capital gain and as the ponzi scheme began, more and more of the world’s glut of funny money poured into the game. Alas, like all Ponzi schemes, eventually the number of new players runs out and the game collapses. Panic selling begins and as asset prices decline, the funny money goes looking for value in real commodities. A rush for commodities and commodity streams and eventually that is overcooked too, signalling the end of the whole box and dice and here we all are. The rapid price rises in commodities recently was everywhere a monetary phenomenon. There is no way 70% steel price rises in the first 6 months of this year was real demand at work, as the collapse in general commodity prices now shows. Certainly demand is dropping as the malinvestments of a decade, due to monetary expansion must now be unwound. This is the inevitable monetary bust and central bankers cannot throw more money at a solvency crisis of their making now. It’s simply a matter of how you like your unwinding now. Short and terrible (depression) or long and very painful (stagflation) How would you like your nasty medicine now folks?

Oh and ask yourself this Fred- How on earth could our Reserve who had lost control of interest rates, drop them any earlier as the market was raising them in response to market risk? It simply had to wait and follow the market down as real investment opportunity collapsed. The only thing stopping interest rates plumetting now is plumetting money supply tracking plumetting demand. Witness my bank Westpac still offering 7.05% at call, interest payable monthly. Didn’t budge with the Reserve’s last edict.

observa
observa
13 years ago

The moral to the story is you can’t trust central planners with printing presses, particularly with their political masters reliant on taxation by stealth via progressive income tax. Neither can you trust central planeers not to manipulate exchange rates, so what does that leave? Redeemable money and a gold standard. It couldn’t possibly be worse than the situation these overstuffed central bank morons have left us with now. Oh and incumbent Govts of course.

observa
observa
13 years ago

Speaking of overstuffed morons trying to justify their salaries and trying to work out where it all went wrong, read between Glenn Steven’s lines-
http://www.news.com.au/business/story/0,27753,24310854-31037,00.html

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
13 years ago

Fred, we continue to run a very large CAD. So why loosen fiscal policy? Why not take as much of the easing as possible on the monetary side – which would also keep the dollar lower. Even though all of a sudden this is less of a problem than it was it still seems sensible to have as much expansion as we can in net exports.

And why run a deficit in NSW (I presume you mean an operating deficit), why not invest in much needed infrastructure.

observa
observa
13 years ago

“Fred, we continue to run a very large CAD”
Well we’ll see how long that lasts now that those orderly, Keynesian oversighted markets have decided our dollar is worth around 80cUS a few weeks after it was worth 98c. Just tweak a few more dials and pull a couple more levers and she’ll all be apples again. Just like the Asian meltdown and Dotcom monetary expansion hankies and now here we all are. When will the Kewynesian, central planning mindset ever desist one wonders? Let their epitaph read- ‘They meant well!’ and hopefully real soon.

Fred Argy
Fred Argy
13 years ago

Nicholas and Pedro: I am not really critical of the May fiscal reaction of the Government, given the contrary view put by Hawks like Richardson and Gittins urging them to cancel the tax cuts. It was a reasonable response in the circumstances.

But now the fiscal realities need to be reviewed. Like you, I have always advocated the implementation of an infrastructure program to stop the economy from enduring a sustained long period of economic drought.

But I would now go further and suggest the states should allow the automatic stabilizers to operate i.e. taking no action to offset the effects of changing economic conditions on unemployment benefits or on tax revenue. This would mean letting the NSW government operating deficit roll on.

In regard to monetary policy, I have much less sympathy. RBA’s policy has been magnificent for the last fifteen years. I suspect they have let the ball slip away badly over the last 12 months.

Observa and JC you are both still in the monetarist school. The main reasons for the failure of monetarism were the technical difficulties in controlling the money stock and the deregulation of financial market and associated innovations, which distorted the significance of money aggregates and precipitated the demise of monetarism.

I thank you for your concern about me, JC. I’m fine for the present.

observa
observa
13 years ago

Basically Fred, among others has some reservations about the conduct of monetary policy, so let the guru himself explain it. None other than the illustrious Glenn Stevens-

“I don’t think the board had got it wrong,”
Hmmm.. well we’ll listen to what you’ve got to say then Glenn

“I doubt very much we could have credibly just sat there with what inflation was doing.”
I guess that’s true on those salaries Glenn and rising prices were getting to be a bit problematic for those not enjoying them.

“On the information we had then on the assessment on the risks that we could make then and even looking back those moves were correct.”
We were on the job earning earning every cent of those big salaries folks!

“The logic of this decision[to cut interest rates] was the same as the one that, some years earlier, had led the board to begin raising rates from unusually low levels: the setting of policy designed to get the economy to change course probably will not be the right one once the change of course has occurred, and it will need to be adjusted.”
Hmmm.. so you might have set interest rates a bit ‘unusually low’ in the past there Glenn. Ah well, I guess you can always raise them until you think they’re about ‘just right’ then mate, although apparently that means things change as a result and you have to make it all up as you go along again. So that’s what the big salaries are all about.

“A further consideration was that conditions recently had actually tightened marginally as a result of rises in lenders interest rates, which from a macroeconomic point of view was not needed.”
Things were getting a bit beyond our control.

“Admittedly, we are probably six months away from seeing clear evidence that inflation has begun to fall, and even then it has to fall quite some distance before it is back to rates consistent with achieving 2 to 3 per cent on average,”
Things are getting out of control when we can’t set inflation at 2-3% on average permanently. Shutup the self-funded retiree asking a stupid question like- ‘Why don’t you target say -3% to -2% Glenn?’ Glenn’s salary is indexed you dummy!

“Rather than trying to achieve that larger fall in inflation [than was the case in either 2001 or 1995] by pushing it down more quickly, the board’s strategy is to seek a gradual fall, but over a longer period,”
This is much different to 1995 and 2001 so stagflation is the best policy.

“This carries less risk of a sharp slump in economic activity, though it does require a longer period of restraint on demand.
“On the other hand, this carries the risk that a long period of high inflation could lead to expectations of inflation rising to the point where it becomes both more difficult and more costly to reduce it.”
We choose stagflation rather than a depression for obvious reasons although the risk with stagflation is depression in the long run perhaps.

“That framework will continue to guide the board’s decision making,”
Something to look forward to no doubt.

“Overall, households are at present much more cautious about spending and borrowing, after a number of years in which confidence levels were very high and there had been strong rates of growth in borrowing and spending,”
Cheer up if you thought households were borrowing and spending because of those unusually low interest rates we set years ago. We’ve fixed that now.

“What we see in the Australian financial scene is an order of magnitude less troubling than what we see abroad,”
Don’t worry, things aren’t as bad as OS and besides we don’t earn those US Fed salaries anyway.

“In summary, the Australian financial system is weathering the storm well.”
On our indexed salaries things are looking OK.

pedro
pedro
13 years ago

Fred, I agree that the RBA should have tightened earlier, though I’m not sure it would have made much difference to the inflation numbers because a lot of the price increases are coming from overseas. I do sympathise with the RBA because they will want to retain anti-inflation credibility rather than lose it the way the Fed seems to be doing.

I don’t pay so much attention to the NSW government’s economic policy, but I suspect that more of the same (which is your continuing deficit) might not be a good long term plan. Some pain has to be taken sometime.

JC
JC
13 years ago

Fred:

Interest rate targeting is problematic. In fact it’s an almost impossible objective. Quantitative targeting offers the best solution as the monetary authority simply decides on a predetermined quantity and allows the market to set short term interest rates.

Fred Argy
Fred Argy
13 years ago

We are getting some odd looking unemployment figures. What we are seeing is an initial decline in labour productivity – a 2% rise in non-farm gross product and a 2.3% rise in employment (perhaps due to a temporary bank-up of unmet demand). The crunch must happen soon.

JC
JC
13 years ago

It’s already happening Fred. The credit crunch is pretty deep now.

JC
JC
13 years ago

Fred:

We shouldn’t be worried about the unemployment figs as that’s a lagger. I think those bozos at Martin place just don’t realize how bad the potential deflation headwind is .

Those guys should be looking at to how quickly they can drop rates rather than worrying about the CPI and the inflation target. There isn’t any inflation to worry about! What we had a was jump in energy prices that seeped right through the economy like a cancer.

The Aussie has fallen 22% in 6 weeks and you have to go back to 1984 to see another move of that magnitude. When the Aussie goes down hard and quickly deflation -global deflation – risk is at the door.

The Aussie banks are in some potentially horrible shape here with further write downs are coming as the US nightmare is still on their balance sheet. There are further writedowns such as Octaviar and those types.

Babcocks is basically looking as though it’s about to open the coffin lid along with the satellites (and that s cool 50 billion in debt). If that sucker goes down the tubes we need to be sure the mums and kids are in the cellar with the trap door locked.

Overseas… Lehman is about to go, the UK is another nightmare waiting to happen. Serious weakness in the PIGS economies (Portugal, Italy, Greece and Spain). Germany doesn’t look great.

I can’t see one arrow pointing up at the moment. Even commodity companies like BHP have been trounced recently which isn’t a good sign for the deflation barometer.

The RBA seems to be in limbo so watch out below. That’s not to say the others are much better. THE ECB is talking about tightening again making me think those clowns don’t know what they are doing as they’re too doctrinaire and could cause the economy to tip right over. This is pretty scary now.

I’m thinking we need co-ordinated global rate cuts right now or it’s all over. I’m mostly cash and still nervous :-)

But don’t let me scare you :-)

Fred Argy
Fred Argy
13 years ago

JC, I certainly agree with your assessment of the ECB. They are literally certifiable.

Anon
Anon
13 years ago

JC,

Given that the $A is falling, doesn’t this mean a sharp increase in import prices? A good example is current petrol prices which remain high despite a drop in world oil prices.

Further, the lower $A will encourage greater production for the export market thus potentially exacerbating the existing capacity constraints.

If so, then we are unlikely to see deflation, but rather the opposite.

JC
JC
13 years ago

Hi Anon:

There are two Aussie dollars in my mind, Anon. There’s a financial Aussie and an Aussie for trade flows. The financial Aussie is much larger.

The Aussie is sometimes a good pointer for the status of world liquidity and global risk appetite. The Aussie does well when the risk jaws are open and there’s money around to take a shot in the riskier end of the market (us). A fall of this magnitude maybe an indication that world liquidity is retracting even further and risk appetite is falling off a cliff. You have to go back to 1984 to see a fall of this magnitude.

All things being equal your comment is right. However we’ve seen commodity prices fall which means the terms of trade has deteriorated somewhat recently.

I would actually argue that an appreciating Aussie due to improvements in the terms of trade is a better combination. It means, we become wealthier compared to the rest of the world, there is demand for our exports and imports are getting cheaper because of the higher Aussie.

In other words demand for the currency brought on by improvement in the terms of trade is better than a falling currency that is trying to dissuade imports because of a slowdown in global growth.

Anon
Anon
13 years ago

Disclaimer: I’m not an economist, but an interested amateur, so you can disregard the following if you wish.

I agree that a strong $A is better than a weak one, nonetheless a lower currency does have benefits. Further, I am puzzled as to why it has fallen at all. Three reasons have been offered to explain its fall:

1) Interest rates in Australia are falling. True, but they are still higher than most other countries and the recent increase was by a paltry 0.25pp.
2) Commodity prices are falling. Also true, but many mining companies have fixed-price long-term contracts.
3) The $US has increased relative to most world currencies, including the $A. True, but given all the financial problems in the US, this recent increase makes no sense. Some commentators believe this is only temporary and the $US will fall again soon.

If you accept the proposition that reduced money supply/high interest rates cause recessions, then the current data do not suggest that we are about to experience a sharp economic downturn.

90 day bank bills were almost 22% prior to the 1974 recession; 21% prior to the 1982 recession, and 18% prior to the 1991 recession. As at July, they were only 7.75%.

Of course, you could simply reject the proposition, or argue that “this time is different.” :)

JC
JC
13 years ago

Hi Anon.

Disclaimer: Im not an economist, but an interested amateur, so you can disregard the following if you wish.

No, These a good questions and worth discussing.

I agree that a strong $A is better than a weak one, nonetheless a lower currency does have benefits.

Well yes it does have the benefit of dissuading imports and enticing foreigners to buy our exports during a time of slow growth. So you could say that a weak currency is necessary (or a symptom of a weak economy). However you also have to be very careful and not turn a depreciation into a predictable long-term trend as you want to see foreigners fund our current account deficit.

The US is a good illustration of a nation “stealing” growth from the rest of the world by adopting a policy of benign neglect towards its currency over the past years. The US experience provides some evidence that firms with international operations or exports were able to take advantage of the weak dollar with the result they showed reasonable sales/profit figures over a period of over the time the US Dollar has been weak. Recent US GDP has done better than expected over the past 2 years or so because of the hyper weak US dollar as US exports have grown solidly.

However a weak US Dollar policy is also blamed for part of the strength in commodity prices which itself is not without problems. So there have been trade offs is maintaining a weak dollar policy including concerns foreigners may not want to hold/own/buy the currency. In fact this has been shown to be the case with recent US C/A stats showing a large proportion of US dollar buyers have been foreign governments or entities aligned with foreign governments as private investors have shied away.

Back to the Aussie dollar………..

There are both costs and benefits in a weaker Aussie dollar. Its not all bad, however we shouldnt lose sight of the fact that a weak dollar has its costs.

1) Interest rates in Australia are falling. True, but they are still higher than most other countries and the recent increase was by a paltry 0.25pp.

True, but the financial market are also forward looking. Although the drop in the overnight rate was 25 basis points the market has seen this as a shift in the RBAs policy position going from a tight to a loose policy. Thats important as the market knows that once a major central bank commences a direction in interest rate policy it usually stays in that heading for a long time. Its like an aircraft carrier in the sense that it takes a long time to change course or stop at all.

2) Commodity prices are falling. Also true, but many mining companies have fixed-price long-term contracts.

True, however the fixed price contracts are usually for a short term such as 12 months. The market is implying for a firm such as BHP yes we know you making bucket loads of cash this year, but we dont expect you to be doing so well 2 years (say) down the road”.

This is where it gets interesting for BHP stock. If you think the market is wrong, BHP looks very cheap, trading at around 4.5 times forward cash flow. If you think it will continue generating these enormous levels of cash for a lot longer, BHP is the steal of the year.

3) The $US has increased relative to most world currencies, including the $A. True, but given all the financial problems in the US, this recent increase makes no sense. Some commentators believe this is only temporary and the $US will fall again soon.

Youre right anon, it could be temporary. However the US Dollar has been vastly oversold over the past 4-5 years and was perceived to be extremely undervalued. Some analysts were suggesting fair value was 30-45% ( US dollar undervaluation) against the Euro and the Pound. The market also began to reassess the economic prospects of the EU and the UK resulting in some material write downs in growth prospects for the European region. Taking into account that the market had thrown everything including the kitchen sink at the US while having ignored the potential slowdown in the EU/UK its not surprising we saw the US strengthen materially. What is surprising is the actual size of the appreciation and the speed in which it happened.

If you accept the proposition that reduced money supply/high interest rates cause recessions, then the current data do not suggest that we are about to experience a sharp economic downturn.

Monetary growth has certainly slowed this financial year. See here
http://www.rba.gov.au/Statistics/financial_aggregates.html
M1 and the monetary base.

In some months it had actually retreated which is in direct contrast to what has happened in the past several years when there was ‘ healthy’ money supply growth.

90 day bank bills were almost 22% prior to the 1974 recession; 21% prior to the 1982 recession, and 18% prior to the 1991 recession. As at July, they were only 7.75%.

I dont think you can look at interest rates alone and argue we are tight or loose in terms of monetary policy. You need to also take the monetary aggregates into account. We could have loose policy even with interest rates at 20% as it all depends on the growth of monetary aggregates.

Of course, you could simply reject the proposition, or argue that this time is different.

I think one also needs to explain why things are different if they are. Look we’re seeing an enormous level of debt de-leveraging going on around the world. Until that finally unwinds things are going to continue to be volatile and very shaky. Some bank analysts are suggesting we’re about 2’3 of the way through. Dunno if this is right or wrong but Credit Swiss is suggesting the world has written down about $800 billion dollars of US$1.3 Trillion.

JC
JC
13 years ago

Correction:

Some bank analysts are suggesting were about 2/3rds of the way through.

JC
JC
13 years ago

Anon:

Rumor is that Lehman is filing chap 11 this evening. AIG (American insurance group) could be downgraded and if it’s downgraded there could a a cash call of up to $50 billion. $50 billion is no chump change even in today’s dollars.

While Lehman may be declaring bankruptcy bank of America is possibly making a bid for Merrill Lynch at a rumored 70% premium all stock offer to Fridays close.

Get the pop corn out, put the feet up as this is gonna be one hell of an interesting day on the financial markets.

Stephen Hill
Stephen Hill
13 years ago
Anon
Anon
13 years ago

JC,

The airlines could be next!!

I think you make some interesting points, but I want to focus on just one: the money supply. While M1 may have contracted to 6%, M3 is rollicking along at 18%.

But which is the best measure of monetary growth? And why?

JC
JC
13 years ago

I think a combo of bits of M1 and M2 is closer to the definition of money that I would use in determining the target.

Why? I think it is closer to the definition of money than other aggregates….

That is Money ( or instruments) of Zero maturity.

JC
JC
13 years ago

Anon:
And don’t worry about the airlines just yet. My bet is that AIG is filing for bankruptcy protection on Wednesday morning NYC time. Someone said they need $75 billion to shore up their capital. Can you imagine the implications of Dow 30 company filing bankruptcy protection? AIG was a huge writer of credit default insurance which means that if they go under the insurance on a lot of the investment grade paper relied on becomes suspect or rather problematic. talk about a vicious circle.