The Reserve Bank’s behaviour last week can only be described as bizarre. It’s a sign that it’s lost its bearings and isn’t sure what’s happening in the economy or where it’s headed. What has caused its befuddlement? Our unexpected return to near full employment. Sheesh. Whadda we do now?
The way “monetary policy” – the Reserve’s manipulation of interest rates – normally works is that, when the rate of price inflation gets too high, it raises interest rates to discourage borrowing and spending. Then, when the demand for goods and services has weakened and the rate of inflation has started slowing, the Reserve starts cutting interest rates back to their normal level.
But that’s not what began last week. After raising the official interest rate by 4.25 percentage points to 4.35 per cent and keeping it there for 15 months, the Reserve cut by 0.25 points, but made it clear it wasn’t sure it should have cut, and warned us not to assume further cuts would follow.
It would wait and see what happened. It didn’t say so, but it left open the possibility that, should inflation start going back up, it would resume raising the official rate.
Huh? What on Earth are these guys playing at? Are rates coming down or aren’t they? It was a case of bureaucratic arse-covering. Hosts of people – those with mortgages, the financial markets and many economists – were demanding a rate cut, and the Reserve didn’t want to get the blame should Anthony Albanese get tossed out at the looming election.
So it sent a signal that rates were coming down, then said it wasn’t a signal. It’s obvious the government was desperate for a rate cut, but note this: at all times Albanese and Treasurer Jim Chalmers have stuck to the agreed etiquette of never publicly expressing any opinion on what the Reserve should or shouldn’t do.
It’s not the first time the Reserve has engaged in arse-covering. Governor Michele Bullock admitted last week that the central bank waited too long before starting to raise rates in 2022. But it made sure it got the first increase in before the May 2022 election, at which the Morrison government got tossed out.
Had it waited until after the election, it would have been criticised for doing the Liberals a favour and, in the process, letting people think the inflation problem arose under Labor.
The point many otherworldly economists don’t get is that just because a central bank is independent of the elected government doesn’t mean it can escape politics. Why not? Because we live in a democracy.
The great contradiction of central bank independence is that, for the bank, it’s all care but no responsibility. If it stuffs up the economy, the governor doesn’t lose her job, the prime minister does. And that’s when the pollies – on both sides – tend to get vengeful.
When a central bank lacks independence, it can leave the politics to the pollies. But if it is independent, it has to do its own politics, which is what Bullock was doing last week.
But why is the Reserve so anxious about cutting rates when underlying inflation is heading down, isn’t far above the 2 to 3 per cent target range, and most economists think monetary policy should be eased? Short answer: because its boffins aren’t old enough to have lived in an economy that’s close to full employment.
Thanks to the excessive monetary and budgetary stimulus applied during the pandemic, the economy boomed and, just after the change of government, unemployment fell to 3.5 per cent, its lowest in almost 50 years. After more than two years of higher interest rates, it’s still only up to 4.1 per cent.
After the review of the Reserve Bank, it was decided to have the longstanding lip-service goal of full employment raised to equal status with the Reserve’s inflation target.
For the past five decades, we and the other rich economies have used a mathematical calculation called the “non-accelerating inflation” rate of unemployment, NAIRU, to give achieving low inflation priority over low unemployment.
This made it easy to get inflation down. You used interest rates to give the economy an almighty hit on the head, causing unemployment to shoot up and the rate of inflation to fall rapidly. Only small problem: you never got back to low unemployment.
This time, however, the Reserve sought to avoid a great worsening in unemployment by not hitting the economy too hard. The consequence has been a slower and less certain return to low inflation. And the jobs market has kept happily steaming along.
Despite flat consumer spending and weak business investment in capital equipment, employment’s still growing strongly and unemployment has risen only a little. The proportion of people with jobs is higher than ever, showing that supply has had no trouble keeping up with demand.
But this is scaring the pants off the Reserve’s boffins. With the labour market so “tight”, surely wages could take off at any moment, halting the fall in inflation – or worse, sending it back up. What’s unnerving them is an old ’70s-model NAIRU machine in the corner, with its red lights flashing and siren blaring. Panic stations. Assume the brace position.
This explains last week’s signal that the Reserve was cutting rates and not cutting them at the same time. When it says what it does next will depend on the data, it means “we’re not really sure what the hell’s going on”.
Trouble is, the world has changed a lot since the invention of the NAIRU machine in the 1970s. The unions used to be able to force excessive pay rises on their bosses, but globalisation, deregulation and the collapse in union membership have changed all that.
The Reserve’s boffins, however, have been so busy with their maths and modelling that they haven’t noticed how much the world has changed. They don’t even seem to have noticed that their regular forecasts of wage growth have been way too high for more than a decade.
No wonder they’re so worried. And until they get the memo, the Reserve will go on punishing everyone impertinent enough to have a mortgage.
