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.)