The silly season saw some respite from endless speculation about the future of interest rates. But not enough. Every economic development and statistic produced a knee-jerk reaction from the pundits. Exchange rate up? "Currency rise takes pressure off Reserve to raise rates." Strong retail sales? "Rate rise back on the agenda." Housing boom slows? Inflation low? "The end is nigh - no more rate hikes." Strong employment growth? Strong (indeed increased) credit growth? "Rate rise imminent."
The reality is that the Reserve Bank knows it left monetary policy too loose for too long. The domestic economy is strong, in fact unsustainably strong, and perceptions about global growth have seen a sea-change in recent months as China booms, the US shows near-record growth and Japan begins to recover after a decade of deflation. The Reserve Bank needs to get monetary policy at least back to neutral as soon as possible. In fact there is every chance it will find itself playing catch-up during the election year that is 2004.
Whether on not the Reserve is severely or only mildly embarrassed in this episode depends on two things. The first is fiscal policy - will it be tightened or eased during 2004? This is largely out of its control, although the Governor should be using all of his ability to persuade the Treasurer and ultimately the Prime Minister to tighten fiscal policy in the coming budget. That means spending cuts and/or tax increases. "Have you lost your marbles, Ian?" would be the likely initial response from the politicians to this suggestion.
The second matter is under the direct control of the Reserve. If the government does not make a responsible adjustment to fiscal policy, the RBA should briskly raise interest rates to slow the growth of domestic demand to a sustainable level. If fiscal policy is eased, the usual expectation in an election year, the rate increases will have to be so much larger. The best technical objection to further tightening in monetary policy is that it will force an uncomfortably high exchange rate even higher. Delaying the monetary tightening in the face of a rising currency was a major mistake in the late 1980s. A repeat of this misguided action now will increase the chances of a nasty economic correction in 2005.
The similarities with events in the late 1980s are already quite worrying.
- Annual growth in real (inflation adjusted) domestic demand is over 5 per cent (see chart).
- Export growth (real) is negative.
- Import growth (real) is above 10 per cent.
- The current account and trade account are both in severe deficit.
- The contribution to growth of net exports is strongly negative.
- Employment growth seems to be slowing.
- Dwelling approvals growth has fallen sharply from excessive levels.
- Credit growth is high - in the late 1980s, however, it was falling from far higher rates while now it is still increasing.
The differences now compared to the late 1980s are mainly related to the fact that global and therefore Australian inflation is substantially lower, and thus interest rates and many nominal (current price) variables are growing more slowly. Low international interest rates have greatly reduced Australia's debt servicing burden, even though Australia's net overseas liabilities are noticeably higher than they were in the late 1980s.
While global interest rates continue to be low, the current situation can persist. But when global interest rates begin to rise, Australia's situation will become more fragile. A relatively sudden rise in global rates would pose a significant threat to Australia, equivalent in its impact to the sudden drop in the terms of trade in 1990.
And of course the very latest bit of economic news is about global interest rates. Late in January, the US Federal Reserve slightly altered its rhetoric, bringing forward the prospect of US rate rises. This has at least temporarily reversed the fall in the US dollar, raised longer-term yields in the US and caused a sudden correction in equity prices. US and therefore global short-term interest rates are at unsustainably low levels. The global economy can fairly be described as booming. Significant increases in US, and therefore global, policy rates are inevitable.
"Australia is living beyond its means, fuelled by easy money and financed by cheap credit. Now is the time to rein in Australia's excessive spending, Prime Minister. Action to tighten the 2004 budget is the responsible action. How you do this is not the RBA's concern. If this is not done, the Reserve Bank will have to raise rates by more than we otherwise would need to, to rein in excessive domestic growth. If neither action occurs, 2005 will very likely see a significant economic set-back for Australia. Responsible action now will mean slower growth in 2004 but greatly minimize the risks in 2005 and beyond. We mean what we say, and will raise rates on the first Wednesday in February to prove it."
This is the advice that the Reserve Bank should be giving the government now. If such advice is not tendered, the Reserve will have failed to do its duty. If the government is so advised and fails to act, the outcome will destroy the government's reputation for economic competence. That would give Mark Latham's Labor party a real chance to form a government.
Over to you, Ian Macfarlane and Peter Costello.
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