Bubble, bubble, toil and trouble for the RBA board and for borrowers. Yesterday's Reserve Bank board meeting was the most important since 2003. The board confronts scenarios that could discredit government policies or severely dent the Governor's reputation - and both are possible.
Governor Ian Macfarlane has ventured some distance out on a limb, advocating pre-emptive tightening to tackle inflation. Although this is far later than Henry Thornton recommended, and this lateness has produced avoidable risks for the Australian economy, we support the approach at this time.
We also support what will almost certainly be a gradual tightening, starting with the modest 25 basis point increase in cash rates under official control. Australia's households have amassed debt far too quickly, a major consequence of delayed monetary policy tightening. But inappropriate fiscal incentives to borrow are also a root cause, as Macfarlane has recently pointed out.
Australia's current account deficit - a measure of the gap between domestic demand and Australia's overall supply - is also too large, a fact that puts Australian monetary policy in "the hands of the market". If global investors decide that the economic prospects here are more subdued, as the inflation outlook dictates, there could be an old-fashioned current account deficit crisis, at which time the RBA would have to step in with a powerful tightening of monetary policy.
Now is not the time for heroic sharp tightening of monetary policy: Instead a cautious series of small 25-basis-point increases, with careful evaluation as the rises take effect.
Since the board's previous meeting in early February, the bank has issued a quarterly Statement on Monetary Policy built around the realisation that Australia faces capacity constraints, that costs are rising and interest rates will have to rise because of the imminent increase in inflation.
The governor has campaigned on these themes in front of the House Economics Committee whose chairman concluded, even at half-time, that the committee had failed to dissuade the governor from the path of raising interest rates. The governor himself had said the board's only discretion concerns timing.
The RBA governor went beyond his normal brief to put the need for urgent economic reforms squarely in front of the Government. The choice was stark.
It is sad but true - that in the immediate future nothing can be done to increase the supply-side of the economy. Within a few months, the supply-side could be freed up by announcing that the fiscal incentives to over-invest in real estate would be removed. But this is probably "politically impossible".
Bringing some retired workers back into the workplace could help a bit, but - again sadly - this seems more likely to be the result of the stick of "welfare reform" rather than the carrot of lower tax rates. It seems hard to raise the participation rate above 64 per cent or lower the unemployment rate below 5 per cent (see graph) without radical change. A good deal later, there will be some relief from the construction of new ports and other investments now under way and the training or import of new skilled and unskilled labour.
Fiscal tightening is a theoretical option, but to do this now, for example by raising the rate of the goods and services tax, would be to risk political suicide. Sir Humphrey would commend it as "courageous".
In the here-and-now, the only effective policy instrument is to raise interest rates. This is the job of the supposedly independent Reserve Bank board. Prime Minister John Howard has said that his election promise about interest rates was only that under the Coalition interest rates would be lower than they were under Labor in the late 1980s. He has also advised the nation, and therefore the Reserve Bank's board, that in his view there is no call for any interest rate rises.
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