My guess is the Reserve Bank is a lot more worried about the weak
state of the economy than it's prepared to admit in its soothing words
and the small downgrade to its growth forecast.
That's the only explanation I can think of for its decision
to cut the official cash rate by 0.25 percentage points last week,
despite governor Glenn Stevens' most recent "forward guidance" that "the
most prudent course is likely to be a period of stability in interest
rates".
The Reserve could have preserved the credibility of its
formal signalling regime by delaying such a tiny rate cut by just four
weeks and using last week's statement to change its guidance, but such
was its impatience that it reverted to its formerly forsworn practice of
briefing selected journalists.
The financial markets got the message - thus giving the
Reserve the self-generated justification that it had to act because the
market was expecting it to - but most business economists didn't. In
their naivety, most economists regard the word of the governor as more
reliable than media speculation.
Despite the rate cut - and the assumption of at least one
further cut - on Friday the Reserve shaved its forecast for real growth
this year by 0.25 percentage points to 2.75 per cent, but left its
forecast for next year unchanged at a midpoint of 3.5 per cent.
So what was so worrying that the Reserve, having sat on its
hands for 18 months, couldn't wait another four weeks so as to protect its
reputation?
The old story. This year has long been expected to be when
mining investment spending falls hardest, leaving a huge hole in
activity, to be filled by the resurgence of the non-mining economy,
particularly ordinary business investment.
The Reserve worries that business investment isn't recovering
fast enough. So, despite having already cut the official interest rate
from its peak of 4.75 per cent in late 2011, it decided to take off
another click or two.
It might make all the difference, but I doubt the high cost
of borrowing is what's holding businesses back from expanding. More
likely, they don't see any great scope for making a bigger buck, and
they're not in any mood to try their luck.
As central banks in other developed economies have
discovered, when "animal spirits" aren't helping, you can get to a point
where even exceptionally low rates do little to encourage borrowing and
spending, when cutting rates to encourage growth is like "pushing on a
string".
There's one exception, however: borrowing for homes. The main
reason the Reserve has waited so long to cut rates further is its fear
this would do more to encourage musical chairs in the housing market -
the buying and selling of existing homes - including yet more negative
gearing.
This doesn't do much to increase economic activity, but does
bid up house prices and so add to the risk of a price bubble developing,
particularly in Sydney and Melbourne.
It also leads to faster growth in household debt. Saul
Eslake, of Bank of America Merrill Lynch, notes that after stabilising
for some years, the ratio of household debt to annual household income
has been rising to more than 150 per cent and will now go higher.
With their official interest rates down virtually to zero,
the Americans, Europeans and Japanese have already got close to the
limits of monetary policy. They've had to resort to "quantitative
easing" (creating money out of thin air), but this has done a lot more
to distort exchange rates and inflate prices in asset markets than it
has to encourage real economic activity.
At 2.25 per cent, our official rate is still well above zero
but, even so, we're close to the point where the costs and risks of a
rate cut threaten to exceed the benefits.
The upshot of the great battle between Keynesians and
monetarists in the 1970s was agreement that monetary policy was the most
effective way to fight the opposing evils of inflation and
unemployment.
By the 1990s, some concluded that manipulation of interest
rates by independent central banks had conquered the problem of keeping
economies on an even keel. Yeah, sure.
We discovered a fatal weakness in the new macro management:
monetary policy was great at controlling ordinary inflation, but when
used to stimulate weak demand it was prone to encouraging excessive
borrowing and asset-price bubbles which, when inevitably they burst,
caused deep and protracted "balance-sheet" recessions.
From our perspective, the answer to our present problem isn't
more risky rate cuts, it's greatly increased federal spending on
infrastructure to fill the hole created by the fall in mining
investment.
