June 2012
One of the big events this year is the Gillard government’s plan to return the budget to surplus in the coming financial year, 2012-13. As the budget papers make clear, this represents the end of the unusual period in which discretionary fiscal policy was used to assist monetary policy in countering the effects of the global financial crisis. Now, although the budget’s automatic stabilisers will continue to be allowed to play their role in assisting to achieve internal balance - a steady rate of economic growth and thus low inflation and low unemployment - discretionary fiscal policy will revert to its primary objective of achieving ‘fiscal sustainability’ - that is, avoiding the build up over time of large levels of net public debt.
So monetary policy is back to being the primary instrument used to achieve internal balance. But that raises a question in a lot of people’s minds: with the banks making their own ‘unofficial’ or ‘out-of-cycle’ increases in mortgage interest rates, or passing on to borrowers less than the Reserve Bank’s full cuts in the cash rate, how effective is monetary policy these days? Is it as powerful as it was as an instrument for influencing the strength of demand and achieving low inflation and low unemployment? We’ll discuss this question first, then we’ll look at what’s happening in the economy and how fiscal and monetary policies are being used to respond to those developments.
Is monetary policy still effective?
The main instrument the RBA uses to achieve its objective is what the media call the ‘official’ interest rate and economists call the ‘cash rate’. This is the cost of borrowing overnight in the money market; the rate at which the banks lend to each other. The RBA keeps the cash rate under very tight control by means of open market operations. Between 1999 and 2007 it was easy to see how the RBA’s ability to change the cash rate led to changes in the rates the banks charged on home mortgages and borrowing by businesses: any change in the cash rate - whether up or down - was soon passed on by the banks to their customers.
But from 2007, in the early days of the global financial crisis, that simple relationship broke down and the banks began making ‘unofficial’ rate changes, usually in association with official changes. Why did things change? Because of the money-market disruption and changed relationships brought about by the GFC.
The cash rate is regarded as the risk-free rate of borrowing overnight and it thus forms the ‘anchor’ for all other short-term and variable interest rates in the market. The other rates will usually be higher than the cash rate, with those other rates’ margin (or ‘spread’) above the cash rate reflecting the extra reward to lenders for the various risks they have taken on: the ‘credit risk’ (of not being repaid), the ‘liquidity risk’ (of being unable to sell the debt security without loss because of limited demand for that security) and the ‘term risk’ (of having your money tied up for a longer period).
During the period up to the start of the GFC, all these risks, and hence margins, stayed steady. So a change in the risk-free anchor could be passed on mechanically to the banks’ borrowers. But the GFC made people in various international markets a lot more conscious of the risks they were running, thus increasing the spreads they were demanding. Some markets actually ceased to operate for a time. This wiped out our banks’ chief competitors, the mortgage originators, which ended up being bought out by the banks. Later on, the prudential supervisors and the rating agencies decided our banks had made themselves too vulnerable to events such as the GFC by relying too heavily on short-term borrowing from overseas money markets. So the banks began trying to lengthen the maturity of their foreign borrowing and also began competing with each other to attract more domestic deposits, particularly term deposits.
These changed conditions meant that, though the cash rate - the risk-free anchor for interest rates - remained the largest single influence over the banks’ cost of funds, that cost was also influenced by other factors, such as the changing spreads required by foreign long-term lenders to our banks and by the higher rates needed to attract more term deposits from Australian savers. Anxious to preserve their existing (very generous) ‘net interest margin’ (the difference been the banks’ average cost of funds and the average rate they charge their borrowers), the banks have become emboldened to pass any increase in their cost of funds on to their customers independent of changes in the cash rate.
After the RBA’s cut in the cash rate of 25 basis points in June, the banks decided to pass on about 20 or 21 basis points, thus demonstrating that the cash rate remains the dominant influence over market rates (in this example, 84 pc) notwithstanding the change in the banks’ circumstances and behaviour.
The more fundamental reason for remaining confident the effectiveness of monetary policy has not been reduced is the RBA’s repeated statements that the interest rates it cares about are those actually being paid by households and businesses, not the cash rate. So it makes whatever changes to the cash rate are necessary to get mortgage rates and business borrowing rates where it wants them to be.
Many politicians and home-buyers are highly disapproving of the banks’ efforts to preserve their profitability by increasing the spread between the cash rate and the mortgage rate. But don’t confuse the question of whether you approve of the banks’ behaviour with the question of whether monetary policy has become less effective. It hasn’t.
Factors affecting the economy
The economy’s being hit by three different factors, at present: one expansionary, one contractionary and one that sounds worse than it actually is - so far, at least. These conflicting factors are affecting different industries differently and different states differently. This is because they’re bringing about a change in the structure of our economy, and structural change is often painful.
The first factor is the resources boom, which is expansionary because higher export prices have added to the nation’s real income and because the mining investment boom is adding to economic activity.
The second factor is the high exchange rate the resources boom has brought about. This is helping to ensure the boom doesn’t lead to higher inflation by directly reducing the prices of imports but also by reducing the international price competitiveness of our export and import-competing industries, particularly manufacturing, tourism and education. This tends to reduce their output and their profits, thus making it a contractionary force.
The third factor affecting the economy is the problems in the developed economies of the North Atlantic, particularly the Europeans’ debt crisis and worries about the survival of the euro. At this stage, Europe’s problems are probably having a bigger effect on the confidence of consumers and business people than they are on any other aspect of the economy.
Fiscal policy
Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Gillard government’s medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. This means the primary role of discretionary fiscal policy is to achieve ‘fiscal sustainability’ - that is, to ensure we don’t build up an unsustainable level of public debt. However, the strategy leaves room for the budget’s automatic stabilisers to be unrestrained in assisting monetary policy in pursuing internal balance. It also leaves room for discretionary fiscal policy to be used to stimulate the economy and thus help monetary policy manage demand, in exceptional circumstances - such as the GFC - provided the stimulus measures are temporary.
After the onset of the GFC, tax collections fell heavily, and they have yet to fully recover. The Rudd government applied considerable fiscal stimulus to the economy by a large but temporary increase in government spending.
The government’s ‘deficit exit strategy’ requires it to avoid further tax cuts and limit the real growth in government spending to 2 pc a year until the budget has returned to a surplus equivalent to 1 pc of GDP. The delay in returning to surplus is caused not by continuing high spending but by continuing weak revenue.
In this year’s budget the government shifted its spending plans around to allow it to keep its election promise to budget for (then actually achieve) a tiny budget surplus in 2012-13. After allowing for unimportant changes in the timing of spending and the effect on demand of particular budget measures, the stance of fiscal policy is much less contractionary than it appears to be, with the Treasury secretary estimating the effect to be less than 1 pc of GDP, which is still significant.
Monetary policy
Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. It is the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. MP is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over the cycle. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.
Aware the unemployment rate was only a little above the NAIRU (the non-accelerating-inflation rate of unemployment) and concerned the resources boom could lead to excessive wage growth, the RBA stood ready to tighten monetary policy throughout most of 2011. But, partly because of the lingering effect of the Queensland floods in early 2011, the economy did not accelerate as much as the RBA had forecast. The outlook for growth in the North Atlantic economies worsened, business and consumer confidence weakened and inflation continued to improve. So the RBA cut the cash rate by a click in both November and December of 2011, lowering it to 4.25 pc. In May it cut by 0.5 points in June by a further 0.25 points, taking the cash rate down to 3.5 pc, more than offsetting the banks’ efforts to preserve their profit margins, and producing a net fall in the interest rates actually paid by households and businesses. With market interest rates a little below their long-run average, the stance of monetary policy is now mildly expansionary.
Conclusion
Should the contractionary stance of fiscal policy combine with other factors to weaken aggregate demand, the RBA has scope to counter this by further loosening monetary policy from its present stance of ‘mildly expansionary’.
