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Decisive action needed in recovery, as well as slump

By Henry Thornton - posted Tuesday, 6 October 2009

Markets expect either one 50-basis-point interest rate hike or two 25-basis-point hikes before Christmas.

I am not so sure that the Australian economy is as strong as suggested in recent speeches by Glenn Stevens and his colleagues, but I naturally defer to them, as making such judgments is their full-time job, aided by teams of Australia's brightest economists.

In any case, Stevens's stated readiness to get on with the task of adjusting monetary policy from current "emergency" settings accords with my consistent advice to avoid tightening monetary policy too little too late during booms.


I interpret the speed and size of the rate cuts from October last year as showing a new predilection for decisive monetary policy action, but it is now, during the recovery, that we shall discover if there has been a highly desirable move towards more decisive action in recovery as well as during scary downturns.

There is another issue for monetary policy: what is the appropriate indicator of inflation? I infer from his speeches that Stevens, like many other central bankers, now believes that asset inflation (or deflation) should be part of the considerations when deciding whether to tighten or ease monetary policy. There is a very obvious reason for this change of focus.

It is that lack of decisive monetary policy action in the last boom was partly due to the fact that subdued goods and services inflation was the guide to policy, and asset inflation was virtually ignored.

Goods and services inflation was held down by the growing influence of China and India as suppliers of cheap manufactured goods, but excess money spilled over into asset inflation. Banks began to lend freely on the basis of rising asset values, borrowers purchased assets as well as goods and services, eventually producing self-reinforcing asset bubbles.

In the leading edge economies such as the US, this process was assisted by innovative packaging of loans that were on-sold to who knows who in a furious chase for ever bigger bonuses by the bankers concerned.

Henry reads the golden legion of central bankers as accepting much of this logic, but hung up on what to do about it. I have a modest suggestion, which if past form is repeated will be ignored, then scorned until finally we will be told this was the approach of the central bank all along.


With the assistance of Julian McCrann of Roy Morgan Research, I have constructed a series called with deliberate provocation "True Inflation". It is a weighted average of four series - underlying CPI inflation (the Reserve Bank's current main guide to action), consumer inflationary expectations (in deference to the regular central banker talk of the need to "anchor" such expectations), house price inflation (representing Australia's favourite asset class) and share price inflation (Australia's second-favourite asset class).

Weights are equal, and it is a job for central bank researchers to decide if better weights might be devised or indeed if other asset classes might be included - tulips in Holland, perhaps, South Sea Corporation stocks in Britain, internet stocks in the US, fine art everywhere. 

True inflation is the solid blue line on the graph (see below). The dotted line is underlying CPI inflation, which as noted is the current "official" indicator of inflation in Australia. The red line shows the cash rate. Solid data for all series only goes back to 1987, although share price data is available for a far longer time. No doubt a longer series of house price data also can be found if the spirit is willing.

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First published in The Australian on October 6, 2009 and on Henry Thornton's blog.

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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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