From a short-term perspective the biggest economic challenge facing the Rudd Government is that posed by the acceleration in inflation over the past six months, and the prospect that, on unchanged policies, inflation will remain above the top end of the Reserve Bank’s 2-3 per cent target band through until mid-2010.
They key phrase here is “on unchanged policies”, because the underlying message from the Reserve Bank is that confronted with such an outlook, policies will not remain unchanged. The Reserve Bank appears to be saying that if other influences - such as a slowdown in the global economy, a tightening in the availability (as distinct from the price) of credit, or appropriate changes in other instruments of economic policy - do not produce this “significant moderation in domestic demand”, then the Reserve Bank will seek to achieve it through further tightening(s) of monetary policy.
Once inflation gets entrenched above 3 per cent per annum, it tends to acquire a self-perpetuating momentum and can only be brought back down again at very high cost in terms of economic activity and employment.
But, as a practical matter, a 2-3 per cent target has been agreed between the Reserve Bank and successive elected governments, and the Reserve Bank will do what it must in order to achieve it - raising interest rates further.
Inflation is not an elevated concern at present because the inflation rate has, for the moment, moved above 3 per cent per annum; it is an elevated concern because there is a significant risk that it will stay above that level for an extended period.
It’s true that monetary policy is a “blunt instrument”. Its impact falls disproportionately on those households with a mortgage - roughly 38 per cent of all households - and on those businesses with relatively high levels of debt. Those with no debt are, at least in the first instance, relatively untouched by rising interest rates - although they may well be affected in a number of different ways by the “second-round” effects of higher interest rates as those who are directly affected adjust their behaviour.
Because of the way in which the exchange rate of the Australian dollar is influenced by the spread between Australian interest rates and interest rates in other countries, tighter monetary policy also impacts relatively more severely on those sectors of the economy which depend on exports for a large proportion of their revenues and on those who compete with imports in the domestic market.
But it’s also true that monetary policy is the only instrument which the Reserve Bank has available to meet its inflation target.
Some might argue that the Bank should be using “other instruments” designed to limit the supply of credit rather than relying solely on adjusting the price of credit. But history strongly suggests that quantity-rationing is no less blunt an instrument than price-rationing, and more easily evaded in ways that ultimately expose borrowers to even greater risk. History also suggests that quantity-rationing has not been very effective in keeping inflation under control.
It might also be argued - albeit only with the wisdom of hindsight - that the Reserve Bank has made some mistakes in handling the one instrument which it now has at its disposal. Such criticism can, however, only be along the lines that the Reserve Bank should have raised rates by more, and sooner, than it actually did.
The Bank should perhaps have been willing to raise rates by increments of more than a quarter of percentage point. In 1994, the Bank raised rates 2¾ percentage points in three months - and stopped what looked like a worrying rise in inflation in its tracks. Mindful, perhaps, of the greater risks stemming from the significant increase in levels of household indebtedness since then, the Bank has taken more than five years to raise rates by the same amount in the current cycle. The series of quarter-of-a-percentage-point increments has clearly lacked the “shock value” of the 1994 episode.
In making such criticisms, however, it should be acknowledged that the Reserve Bank cut rates by less at the beginning of this decade, and began raising them sooner, than any other major central bank in the developed world (with the exception of its counterpart in New Zealand).
This is an edited version of a talk given to the New South Wales Fabian Society on February 20, 2008. The complete version is available here (PDF 45KB).
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