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It's only a matter of time until an interest rate rise is unavoidable

By Henry Thornton - posted Wednesday, 7 April 2004

The Reserve Bank has been widely applauded by others for its "masterful inaction" in failing to raise interest rates in February and March. But not by Henry Thornton. The easy opportunities to set appropriate monetary policy firmly ahead of the pressures inevitable in an election year have been lost.

The election timing will be clearly in the governor's mind - as revealed in this newspaper at the weekend. Clearly, senior politicians have already provided plenty of coaching. The Keelty affair will have reminded Ian Macfarlane what real political heat might feel like.

Perhaps the dominant influence on Australia this year - on the economy and how monetary policy needs to be conducted but also on the timing of the Australian election - will be events in the USA. The deteriorating situation in Iraq makes it unlikely that an Australian government would want to go to the polls after the US. Equally, President Bush's cause is not yet lost. Friday's buoyant US jobs data has certainly created a sense of euphoria in equity markets. While the US President is no doubt feeling a bit happier, global financial markets know that the time for US interest rate increases, while not imminent, is getting nearer.


Australia's May budget provides the other frame of the electoral window. Barring a geopolitical shock, Australia's election will be after June and before the end of October. By convention, interest rates can hardly be raised near Budget-time, so the scope for RBA action is becoming severely constrained.

The RBA has some longer-term locally-grown worries, all of which will be exacerbated when foreign interest rates begin to rise. The build-up of household debt is one concern, fuelled as it has been by the housing bubble it allowed to grow dangerously. And the build-up of international debt, itself partly fuelled by the housing boom, threatens a significant correction, similar to that in the early 1990s "recession we had to have".

The economy is less vulnerable to such a correction now because it is structurally stronger and, in particular, global interest rates are far lower. Of course, a bigger component of Australia's external deficit is related to our weak trade position than was the case in the late 1980s, with our debt servicing correspondingly lower, courtesy of those low global interest rates. But this is the key point: once those global interest rates begin to rise, Australia's current account deficit will deteriorate quickly from an already unsustainable position.

March saw a spectacular flattening in the Australian yield curve and a period of weakness for the Australian dollar. Markets were painting a picture of imminent recession.

But in reality little in March had materially changed and on balance the prospect of sustained growth is probably now greater than the likelihood of sustained weakness. True, some of the fizz has gone out of the speculative end of the housing market but for each welcome anecdote of seller misery there is another of frustration among would-be buyers, and credit growth still runs too fast. The pipeline of building activity remains firm. Commodity prices are high, and expected to move higher. Inflation is still in the target range only because of the lagged effects of the A$'s appreciation - an influence that will have disappeared by the third quarter of 2004 unless we see more competitiveness lost from a renewed assault on US$0.80. Clearly, there will be an inflation problem when the A$ ceases to rise and especially when it falls. Non-tradeables prices will determine the pace at which the overall CPI rises.

Global events have changed only cosmetically since the RBA Board last met. The Madrid bombings of course dampened sentiment already depressed by the difficulties confronted in Iraq but overall the outlook is still for strong global recovery. The Japanese economy has awoken from its 14-year slumber, and its recovery threatens a global surge in bond yields. China has proved more courageous than many others, with the central bank tightening to reduce overheating risks. As mentioned, US jobs growth has resumed. One problem is that oil prices have risen again, with market equilibrium widely expected to require still-higher prices.


Meanwhile, the federal government has announced a significant boost to spending - with more to come - supplemented by tax cuts. It seems the government is intent on adding about 1 per cent of GDP to demand through the Budget.

The strategy for monetary policy in these circumstances is problematic. Should monetary policy be directed to undo the damage the expansive fiscal policy is likely to create? We know that in the long run the answer must be yes. But in the short-term, this is a democracy. According to the behaviour of the politicians, no rate rises are to be countenanced, or even any cutting comments about fiscal excesses.

The only way we can rationalise the RBA's monetary tactics is to see it as seeking to muddle through until the election. Of course, if the election is too late, the Board may have to act. For instance, if inflation rises in the September quarter because the A$ is no longer rising or oil prices are too high (and we won't have to wait for the official CPI release because the very timely TD Securities/Melbourne Institute monthly data will show the trend), it would have a compelling reason to tighten immediately.

As we said in February and again in March, action then to raise interest rates would have been the safer course. Now the election cycle is in full swing and a rate hike will be seen as a vote against the Liberal budget and - implicitly - for Mark Latham's resurgent Labor. We are resigned to the idea that this month the Reserve will again remain quiet in its tower at the top of Martin Place, hoping not to be noticed. In our view this will be another lost opportunity but the RBA will have to be around to pick up the pieces when global interest rates begin to rise. Its governor and board will be hoping fervently that this is after the next federal election.

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Article edited by Betsy Fysh.
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This article first appeared in The Australian on 6 April 2004.

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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at

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