May 2017
The global economy is enduring a long period of strange and tricky developments, and so is our economy. The world is still recovering from the global financial crisis of 2008, the Great Recession it precipitated, and the very high levels debt that linger as a result of heavy borrowing before, during and after the crisis. Growth has been weak, as has measured productivity improvement. Growth has been so weak for so long that America, Britain, the euro zone and Japan have all resorted to “quantitative easing” – central banks creating money. This unconventional monetary policy has not been very effective at stimulating demand for goods and services, but it has done much to inflate prices in asset markets such as share markets.
Our economy has had to exist in a global environment of low growth, weak productivity improvement, low inflation and weak wage growth, while we cope with the transition from the decade long resources boom – the biggest and most economy-changing boom since the Gold Rush. We’ve had a long period of below-trend economic growth, low business investment and falling real national income, as the income gained from growing production of goods and services, GDP, was reduced by the deterioration in our terms of trade (the prices we receive for our exports relative to the prices we pay for our imports), which has raised Australia’s international cost of living, so to speak.
Our official rate of unemployment is not particularly high, but our rate of under-employment is. Employment growth hasn’t been strong, and most of the extra jobs have been part-time. Young people leaving education have suffered longer than usual waits before finding suitable full-time jobs. Wages have been growing at their lowest rate since the severe recession of the early 1990s – less than 2 per cent a year – and although price inflation has also been unusually low, wages and prices have been running neck and neck, meaning real wages have been stagnant. This is at a time when the productivity of labour has been improving, which you would normally expect to be reflected in rising real wages.
Stagnant real wage growth is bad news for workers, but it also for retail businesses, whose sales don’t grow much, and for governments, whose tax collections don’t grow as fast, especially as no real growth in wages means little bracket creep (fiscal drag). This, in fact, does much to explain the difficulty the Turnbull government is having returning the budget to surplus.
And while all this is going on, the Reserve Bank has been having a lot of trouble using conventional monetary policy to get demand growing more strongly and get the inflation rate up into its target range of 2 to 3 per cent. For some years, the Reserve has been appealing to the government for help from fiscal policy in stimulating demand, and in this year’s budget the government signalled a change.
I want to bring you up to date on recent developments in monetary policy and fiscal policy, and then discuss the effectiveness of the two policies.
The monetary policy “framework”
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. Monetary policy is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over time. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.
Recent developments in monetary policy
The RBA cut the official interest rate hard in response to the GFC in 2008, but then put rates back up once it became clear a serious recession had been averted.
In November 2011, the Reserve decided the resources boom was easing and would not push up inflation. It realised growth in the non-mining sector of the economy was weak - held down particularly by the dollar’s failure to fall back in line with the fall in export prices – at a time when mining-driven growth was about to weaken. So it began cutting the cash rate, getting it down to a historic low of 2.5 per cent by August 2013.
For the next 18 months, the Reserve sat back and waited for this very low interest rate to work through the economy and have its effect. Not all that much happened, with the economy continuing to grow at a below-trend rate. The dollar did start falling in the first half of 2013, and by June 2015 it had dropped to about US77 cents (from its peak of US1.10 in mid-2011), but this would have been explained much more by the continuing fall in coal and iron ore export prices than by our lower interest rates relative those in the major advanced economies. The Reserve continued to note that the exchange rate hadn’t fallen by as much as the fall in commodity prices implied it should have, explaining this as a consequence of the major advanced economies’ resort to quantitative easing, whose main stimulatory effect on their economies came by forcing their exchange rates lower (thus causing ours to be higher than otherwise).
So in February 2015, after a gap of 18 months, the Reserve resumed cutting rates, dropping the official rate twice in 2015 and twice in 2016 to record low of 1.5 per cent. There have be no further cuts so far this year.
The total fall of 3.75 percentage points since November 2011 has helped boost economic growth somewhat. In particular, it prompted the boom in the housing market, causing big increases in house prices and new home building, particularly in Sydney and Melbourne. How much the lower rates contributed to the fall in the exchange rate is debatable.
Monetary policy’s reduced effectiveness
The continuing below-trend economic growth despite a major easing in monetary policy, and plenty of time for it to work its way through the economy, suggests monetary policy easing no longer has as much effect as it used to in stimulating demand. Similar conclusions drawn in the major economies may be explained by their need to resort to the less-effective quantitative easing once official interest rates had been cut to zero. But that doesn’t apply to Australia, and there is no reason to suppose monetary policy has become less effective simply because interest rates here are a lot lower than they used to be.
You know that changes in monetary policy affect demand and, eventually, inflation, via various “channels”. In his last speech before retiring, the former Reserve Bank governor, Glenn Stevens, said he’d long held the view that monetary policy’s main effect on demand was via households, rather than businesses. This was because businesses’ decisions about investment were influenced more by their assessment of the outlook for growth and profits than by the cost of capital – interest rates. So the main channel through which expansionary monetary policy works is to use lower interest rates to encourage households to borrow and spend more. Stevens then argued that this hadn’t been as effective in recent years because our very high level of household debt (most of which is for housing) was making people reluctant to borrow a lot more. It seems clear the new governor, Philip Lowe, agrees with this assessment. He has made the point that monetary policy’s reduced effectiveness is likely to be asymmetrical: if households’ high debt stops cuts in interest rates from encouraging much additional demand, this should mean that increases in interest rates were a lot more effective in discouraging demand (because households’ high levels of debt mean a rise in rates causes a bigger hit to their cash flow).
There is little doubt that the long period of unusually low mortgage interest rates has done much to encourage increased borrowing for housing, particularly in Sydney and Melbourne, making already high levels of household debt even higher. House prices have risen at huge and worrying rates, with competition from housing investment buyers making it a lot harder for young people to afford their first home. In some other state capitals, however – notably, Perth – house prices have been weak. This is a reminder of one longstanding drawback in using monetary policy to control demand: you can have only one, uniform interest rate for the whole economy, even though demand is too strong in some states and too weak in others.
There is continuing speculation in markets and the media on whether the Reserve will cut rates further – to get demand growing stronger and inflation back up into the target range – or whether it will start raising rates to stop the rapid rise in house prices and Sydney and Melbourne. My guess is the Reserve wouldn’t mind being able at do both at the same time. Since this is impossible, it is pleased to have help from “macro-prudential” measures taken by the bank regulator, the Australian Prudential Regulation Authority, APRA, in tightening its direct controls over banks’ lending for investor housing.
At the same time, however, the new governor, Philip Lowe, stepped up his pressure on the Turnbull government (echoed by the IMF and OECD) for fiscal policy to give more assistance to monetary policy in encouraging demand. The government has been preoccupied with achieving fiscal policy’s primary goal of “fiscal sustainably” (ensuring the level of government debt doesn’t get too high) by attempting to get the budget back to surplus - though with little success because of the weak growth in tax collections.
Lowe has argued that the government should draw a clearer distinction between its spending for capital (infrastructure investment) and its spending for recurrent (day-to-day) purposes. It should focus on getting only the recurrent or “operating” balance back to surplus, which would leave it free to give more support to demand, as well as do more to improve productivity, by continuing to borrow for worthwhile infrastructure projects. In this year’s budget the government responded to this pressure, giving more prominence to the net operating balance – the NOB - and by initiating two big infrastructure projects, the second Sydney airport and the Melbourne to Brisbane inland freight railway, with more capital city road and rail projects to come.
Fiscal policy “framework”
Fiscal policy - the manipulation of government spending and taxation in the budget - is conducted according to the Turnbull government’s medium-term fiscal strategy: “to achieve budget surpluses, on average, over the course of the economic cycle”. 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.
Recent developments in fiscal policy
This year’s budget was aimed at restoring the Turnbull government’s ailing political fortunes. Economically, its objective was to put the budget and the return to surplus on a stronger footing by accepting that this would require tax increases as well as spending cuts. It removed from the budget’s forward estimates expected savings from the “zombie” spending cuts – cuts announced in the 2014 budget, but not passed by the Senate. This book entry worsened the expected budget balance by $2 billion in the budget year, 2017-18, with a total worsening of more than $13 billion over four years. The new policy decisions announced in the budget – mainly involving tax increases - will have a negligible effect on the budget balance in the budget year, but yield a $20 billion improvement over four years.
The main revenue-raising measures are a small indirect tax on the liabilities of the five biggest banks; a further 0.5 percentage point increase in the Medicare levy in two years’ time, intended to cover the rising cost of the national disability insurance scheme; and increases in university fees, plus a lower income threshold at which former students must start to repay their debt.
The budget papers project the underlying cash budget deficit falling from $38 billion (2.1 pc of GDP) in the old financial year to $29 billion (1.6 pc) in the coming year and reaching a tiny surplus in 2020-21, unchanged from last year’s budget.
However, these figures exclude a net increase in infrastructure spending – on the national broadband network, the second Sydney airport and the inland railway of about $5 billion, which has been hidden in the headline cash deficit. Allowing for all these factors suggests the “stance” of fiscal policy adopted in this budget is expansionary, but only mildly so. This does, however, represent a positive response to the RBA’s request for more help from the budget in stimulating demand, help that will grow as new projects get underway.
