Why did profit-hungry banks act so quickly to cut interest rates

By MILLIE MUROI, Economics Writer

Like dominoes, the country’s big four banks moved briskly on Tuesday, pledging to knock down their interest rates – some within minutes of the Reserve Bank’s decision to cut the cash rate for the first time in more than four years.

The country’s oldest bank was the first to jump, one minute after the Reserve Bank’s rate cut. From March 4, Westpac’s variable home loan rates will fall by 0.25 of a percentage point, reducing the monthly repayment on an average $600,000 mortgage by about $100. Sixty seconds later, National Australia Bank said it would cut its variable home loan rates by the same amount – effective a week earlier, on February 28. Commonwealth Bank and, later in the day, ANZ followed.

The banks aren’t always so quick. In fact, they tend to jump at the chance to raise their rates (which fattens up their profits), but drag their feet when it comes to passing on decreases in the official interest rate. And this series of moves will eat into their profits. So, what made them move so quickly?

Treasurer Jim Chalmers says he picked up the phone to the big four bank bosses shortly after the Reserve Bank’s decision on Tuesday to talk about their pricing. But it wasn’t Chalmers who sealed the deal. The four major banks were already well on their way to passing on the rate cuts in full, he said.

Instead, Chalmers’ chats with the bosses were a clear-as-day signal of what the banks had already factored in: the political pressure they would face if they didn’t cut rates (not to mention the potential media storm and backlash from mortgage holders pushed to their limits in recent months).

The rate cut was a scenario all of them had considered well in advance of the decision.

It’s no secret that those with mortgages have been squeezed after 13 rate rises in three years. So the first rate cut was always going to be an attention-grabber.

As AMP chief economist Shane Oliver points out, there’s an especially strong focus on interest rates in Australia because of the large proportion of home owners with variable rate loans (in which the interest rate tends to move in line with the cash rate rather than being fixed at a set rate), and the increasing level of debt we tend to carry.

“It’s become a lot harder for banks to dilly-dally and take time with their decisions,” he says.

Then there’s the state of the home loan market, in which banks are still competing quite hard to attract and retain customers. This level of competition probably also put a flame under the backsides of banks when deciding whether to cut their interest rates.

The rapid movements were also partly a reflection of the banks’ size. Australia’s banking sector has had some new smaller and digital banks enter the equation, but it’s still what’s called an “oligopoly”: a handful of businesses with control over rather large slices of the market.

They’re not supposed to be able to collude (for example, by all agreeing to move prices by the same amount) because our competition laws prohibit that. But as John Storey, head of Australian bank research at UBS, points out, the nearly simultaneous movement is indicative of a fairly cosy oligopoly, where once one business breaks from the pack, others tend to follow quite quickly.

In a more competitive market (with more banks), Storey says, it’s possible the banks would act more independently. They might be more incentivised to break further away from their peers by, for example, cutting their rates by a deeper amount.

But in a market with only a few big competitors, each business closely watches the others, and their pricing decisions heavily influence the actions of competitors. A bank cutting its rates too much, for instance, might be met with retaliatory price cuts that just lead to lower profits for everyone.

As Morningstar banking analyst Nathan Zaia puts it, banks don’t want to unnecessarily drive down profit margins for the entire industry.

So, while there was pressure from consumers (and politicians) to pass on the full interest rate cut from the Reserve Bank, and all four banks quickly fell into line, there wasn’t as much incentive to slash rates any further.

There is bad news for savers. The banks will also almost certainly try to minimise lost profit by making similar cuts to interest rates on deposits. That means that although mortgage holders will be breathing a sigh of relief, savers will probably see a fall in interest they earn on their bank balances.

Finally, it’s worth understanding what exactly the “cash rate” targeted by the Reserve Bank is. It’s essentially the interest rate for banks borrowing from – and lending to – each other overnight. You might ask, what’s this mysterious nocturnal activity?

Basically, banks need enough cash every day to serve their customers – and a bit extra (called the “reserve requirement”) in case they suddenly face a wave of withdrawals they weren’t expecting. Depending on the amount of lending, depositing and withdrawing their customers do on any given day, banks might end up with more (or less) cash than they need.

So, at the end of every business day, the banks with more money than they need lend to banks facing a shortage. The Reserve Bank pushes banks to lend and borrow to each other at (or very close to) its cash rate target. How does it do this? By being a bank for the banks.

Basically, the Reserve Bank can hold onto deposits from the banks (called “exchange settlement balances”). The interest rate that banks can earn on these deposits is a bit lower than the cash rate target. That makes banks a lot keener to lend to each other, rather than depositing their extra cash with the Reserve Bank.

Meanwhile, borrowing from the Reserve Bank costs banks a bit more than the cash rate. So any banks needing money are much keener to borrow from their banking peers, which, remember, would rather lend their money out than leave it with the Reserve Bank.

By putting these parameters into place, the Reserve Bank basically creates a narrow “corridor” around the cash rate that determines the cost of banks moving their money around. These costs are then typically passed on to consumers. A lower cash rate for banks usually means lower interest rates for consumers, and vice versa.

The rapid response from the banks this week is certainly no promise of what we’ll see following future Reserve Bank decisions. What seems like a dent to the banks’ profits, and a win for customers, was almost certainly a calculated decision by the banks. They just weighed up the political, social and economic costs of dilly-dallying.

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Sorry, this isn't the day we stop feeling sorry for ourselves

I’m sorry to be the one to break it to you, but I very much doubt that this small cut in interest rates will be the circuit breaker everyone from Treasurer Jim Chalmers down has been hoping for. After our many months of longing for this moment, such a modest saving can only be an anticlimax.

I doubt this will be the reason the economy begins to recover as we all go out and shop. Nor will it be the sea change that secures another term in office for Prime Minister Anthony Albanese.

Consumers and voters are in a sullen, sour mood and have been for a year or two. We’re feeling so sorry for ourselves it will take a lot to lighten us up and make us forget our obsession with the cost of living. Even if things improve, our negativity may lift only slowly over many months.

Normally, a change of government would help a lot. New leaders get a honeymoon in which hope springs eternal. The taller and better-looking the new guy is, the better their chance of making a good impression.

But it’s hard to see a man whose specialty is making us feel angry or afraid being the bloke to cheer us all up.

For someone with a mortgage of $600,000, a rate cut of 0.25 percentage points is worth about $23 a week.

Do you remember Chalmers’ tax cuts last July? No one was terribly excited about them. But they were worth $34 a week for someone on $84,000 a year, and $54 week for someone on $122,000 a year.

There may be more cuts to come this year, of course, even a possible two more before an election held in mid-May. But from what the Reserve Bank is saying, I doubt it’s in a tearing hurry to keep cutting.

And though the Reserve raised interest rates by 4.25 percentage points over the 18 months to November 2023, I don’t expect it to cut rates by more than about 1 percentage point, leaving the official interest rate at about 3.35 per cent.

Why? Because its 4.25-point increase brought the rate up from its crisis level of almost zero during the pandemic and its lockdowns. Now the Reserve will be getting the rate back to normal, not crisis territory.

And while we’re all feeling so sorry for ourselves, don’t forget this. Normally, by the time the Reserve starts cutting interest rates the economy is in recession and unemployment is way up.

Our economy is becalmed, but in nothing like a recession. Right now, we have a higher proportion of the working-age population in jobs than ever before. At 4 per cent, our rate of unemployment is lower than it’s been in most of the past 50 years. Sound terrible to you?

Indeed, it’s the remarkable strength of our jobs market that’s the main reason the Reserve has been so reluctant to cut interest rates until now, and remains “cautious” about cutting them further.

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The nation is finally coming to grips with home affordability

Right now, the prospect of much improvement in being able to afford a home of your own isn’t bright. We don’t look like solving the problem any time soon. But I’ve been watching and writing about the steady worsening in housing affordability for the best part of 50 years, and I’m more optimistic today than I’ve ever been.

Why? Not because we’ve got the problem licked – and certainly not because mortgage interest rates will soon be coming down – but because it’s become so bad no one can go on ignoring it. At every level, from governments at the top to mums and dads and angry young people at the bottom, we’re realising that house prices just can’t be allowed to keep going up and up forever.

For the first time in my experience – and probably the first time since the housing crisis immediately after World War II – all of us are realising something must be done to turn things around. Politicians, treasuries, economists and parents are coming to grips with the problem. We’ve begun thinking hard about all the factors contributing to the problem and the many things that will need to change.

Until now, people have focused on fixing this favourite factor or that one. Now we’ve finally realised the problem is multi-faceted and needs to be attacked at every level from every angle. There’s no magic bullet.

Although affordability has been worsening for decades, the disruptions of the pandemic and its lockdowns – closing our border then reopening and having people flock in – have made the problem acute as well as chronic. It’s the same in other rich countries, but I bet ours is worse.

For many years, politicians on both sides and at both levels of government expressed sympathy for “first home buyers” but didn’t really care. That’s because voters who own their home far outnumber those who don’t, and home owners love seeing the value of their home going higher and higher.

But now home owners are joining the dots and realising their growing wealth comes with a major drawback. Their kids can’t afford a home without big withdrawals from the bank of mum and dad. Why is this a smart way to run the country?

People complaining about housing affordability tend to blame the federal government. In fact, it’s the state governments that have most influence over how many new homes are built, where they’re located and whether there’s enough higher-density housing in the parts of cities where people most want to live.

That’s why the Albanese government’s National Housing Accord with the states is a big advance. That’s true even though their agreement to deliver 1.2 million new dwellings over the five years to mid-2029 is running well behind schedule and may not be achieved.

The accord is important because it represents both levels of government accepting responsibility for housing affordability and being willing to co-operate in making progress. The time-honoured way to get the states pulling their weight is for the feds to pull out their chequebook. Which they have.

You don’t need an economics degree to see that if house prices keep rising it must be because the demand for homes is growing faster than their supply. That’s true, but it’s not that simple. For one thing, if all the extra houses are on the city’s fringe, people who want to live closer in will still be bidding up the prices of the better-located houses and units.

That’s why a big part of the deal with the states is for them to permit more better-located higher-density apartments. This switch of emphasis from doing things to reduce the demand for housing (by ending the tax breaks that help investors outbid first home buyers) to increasing the supply of well-located homes is a big step forward in the thinking of politicians, econocrats and economists.

But we’ll probably need to reduce demand as well as increase supply – so don’t think you’ve heard the last on “negative gearing”.

And don’t assume that if the NIMBYs have been beaten back and permission given for more middle-ring high-rise, they’ll start springing up in a few months’ time. Now the experts have their minds focused on housing, we’ve realised our home-building industry isn’t in tip-top shape. When demand surges, the businesses are much better at whacking up their prices than at building a lot more homes.

Right now, the industry’s discovered it can’t get the tradespeople it needs to expand its production. That’s why, at present, it’s building fewer homes than usual when it should be going flat-chat. We’re told it has lost a lot of its tradespeople to the construction of transport and other infrastructure for … the state governments.

Well, maybe. But my guess is the industry long ago gave up ensuring it was training lots of apprentices because they’d be needed in the next building boom. Similarly, the bureaucrats issuing visas to skilled immigrants don’t seem to have worried much about how their decisions would affect the building industry.

In the post-war years, state governments built and owned thousands of homes rented to people in need. But that went out of fashion decades ago, and now they own little social housing. Changing that will be another part of what’s needed to get housing affordability under control.

Finally, the Reserve Bank. The modest falls in mortgage interest rates we’ll see this year and next are unlikely to do anything lasting to improve housing affordability. When you’ve got a shortage of homes, making it a bit cheaper to borrow just allows someone to win the auction by paying more than the other bidders.

The Reserve has always denied that its use of the interest rate lever to keep inflation low has any lasting effect on housing affordability. But this assumes its ups and downs never cause borrowers to do crazy things for fear of missing out. Maybe the Reserve will need to change too.

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Why we'd be mugs to focus on the cost of living at the election

It’s a good thing I’m not a pessimist because I have forebodings about this year’s federal election. I fear we’ll waste it on expressing our dissatisfaction and resentment rather than carefully choosing the major party likely to do the least-worst job of fixing our many problems.

Rather than doing some hard thinking, we’ll just release some negative emotion. We’ll kick against the pricks – in both senses of the word.

We face a choice between a weak leader in Anthony Albanese (someone who knows what needs to be done, but lacks the courage to do much of it) and Peter Dutton (someone who doesn’t care what needs to be done, but thinks he can use division to snaffle the top job).

By far the most important problem we face – the one that does most to threaten our future – is climate change. We’re reminded frequently of that truth – the terrible Los Angeles fires; last year being the world’s hottest on record – but the problem’s been with us for so long and is so hard to fix that we’re always tempted to put it aside while we focus on some lesser but newer irritant.

Such as? The cost of living. All the polling shows it’s the biggest thing on voters’ minds, with climate change – and our children’s future – running well behind.

Trouble is, kicking Albanese for being the man in charge during this worldwide development may give us some momentary satisfaction, but it will do nothing to ease the pain. Is Dutton proposing some measure that would provide immediate relief? Nope.

Why not? Because no such measure exists. There are flashy things you could do – another big tax cut, for instance – but they’d soon backfire, prompting the Reserve Bank to delay its plans to cut interest rates, or even push them a bit higher.

We risk acting like an upset kid, kicking out to show our frustration without thinking about whether that will help or hinder their cause.

Rather than finding someone to kick, voters need to understand what caused consumer prices to surge, and what “the authorities” – in this case, Reserve Bank governor Michele Bullock and the board, not Albanese – are doing to stop prices rising so rapidly.

The surge was caused by temporary global effects of the pandemic – which have since largely gone away – plus what proved to be the authorities’ excessive response to the pandemic, which is taking longer to fix.

It’s primarily the Reserve Bank that’s fixing the cost of living, and doing it the only way it knows: using higher mortgage interest rates to squeeze inflation out of the system. But doesn’t that hurt people with mortgages? You bet it does.

What many voters don’t seem to realise is that, by now, the pain they’re continuing to feel is coming not from the disease but the cure. Not from further big price rises but from their much higher mortgage payments.

So it’s the unelected central bank that will decide when the present cost-of-living pain is eased by lowering interest rates, not Albanese or Dutton. A protest vote on the cost of living will achieve little. Of course, if you think it would put the frighteners on governor Bullock, go right ahead. She doesn’t look easily frightened to me.

But there’s another point that voters should get. When people complain about the cost of living, they’re focusing on rising prices (including the price of a home loan). What matters, however, is not just what’s happening to the prices they pay, but what’s happening to the wages they use to do the paying.

When wages are rising as fast as prices – or usually, a little faster – most people have little trouble coping with the cost of living. But until last year, wages rose for several years at rates well below the rise in prices. Get it? What’s really causing people to feel cost-of-living pain is not so much continuing big price rises or even high mortgage payments, but several years of weak wage growth.

Why does this different way of joining the dots matter? Because, when it comes to wages, there is a big difference between Albanese and Dutton.

Since returning to government in 2022, Labor has consistently urged the Fair Work Commission to grant generous annual increases in the minimum award pay rates applying to the bottom fifth of wage earners.

This will have helped higher-paid workers negotiate bigger rises – as would Labor’s various changes to industrial relations law. Indeed, this is why wages last year returned to growing a fraction faster than prices.

These efforts to increase wage rates are in marked distinction to the actions of the former Coalition government. So kicking Albanese for presiding over a cost-of-living crisis risks returning to power the party of lower wages.

But here’s the trick: it also risks us taking a backward step on climate change. The party that isn’t trying hard enough could be replaced by a Coalition that wants to stop trying for another decade, while it thinks about switching from renewables to nuclear energy.

From the perspective of our children and grandchildren, the best election outcome would be a minority government dependent on the support of the pollies who do get the urgency of climate action: the Greens and teal independents.

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Will Trump be disastrous for our economy? I doubt it

When, in its wisdom, the American electorate does something really stupid, it’s tempting to predict death and disaster for the whole world, including us.

But though the Yanks are embarking on a bout of serious self-harm – and this will have costs for the rest of the world economy – let’s not kid ourselves that we’ll be prominent in the firing line.

Leaving aside Donald Trump’s climate change denial – a topic I’ll get to another day – his most damaging stated economic policy is to make America great again by imposing a tariff (import duty) of 10 to 20 per cent on all America’s imports except imports from China, which will cop 60 per cent.

This is rampant populism – it sounds like a great idea to those who understand nothing about how economies work but it will make the US economy worse rather than better. Trump claimed this new tax would be paid by the foreign suppliers but, in reality, it will be paid by those American consumers and businesses that continue to buy imported items.

So the man who got elected because the punters hate inflation will be acting to worsen inflation. This isn’t likely to do much to increase the demand for locally made manufactures but, to the extent that it does, automation and digitisation will mean it does little to create more jobs in manufacturing.

Another reason protectionism doesn’t work is that America’s major trading partners – particularly China and Europe – are likely to retaliate by imposing tariffs on their imports from America. We know from history that trade wars end up leaving both sides worse off.

So the United States will suffer most, although all countries that trade with it will suffer to some extent. But get this: the US is not one of our major trading partners. It takes only about 5 per cent of our exports. Our big partners are China, Japan and South Korea.

Like many ignorant Americans, Trump believes any country that runs a bilateral trade surplus with the US must be doing so because they’re cheating in some way. Not a problem for us: we import more from the Yanks than we export to them. It’s China and the Europeans Trump will be going after, not us.

To the extent that Trump hurts the Chinese economy – as part of the Americans’ bipartisan obsession with trying to prevent China usurping their place as the world’s top dog – that will have an adverse flow-on to us.

But the Chinese have their own ways of fighting back. In any case, the greatest risk to our economy is not from what the Yanks do to the Chinese but from what the Chinese stuff up on their own account.

While it’s clear Trump is well placed politically to press on with implementing the crazy policies he has promised, that doesn’t mean he’ll do everything he’s said he’ll do to the full extent that he’s said. For instance, why would he tax all imports of goods and services when it’s manufactures he’s really on about? Also, not everything he tries to do will be done in next to no time.

We know the man. He’s nothing if not capricious. Dead keen one minute, moved on the next. And as someone who sees himself as the great dealmaker, he’s highly transactional. A 20 per cent tariff may be just the list price before the bargaining starts. ANZ Bank economists say the average tariff on Chinese goods will go from 13 per cent to 22 per cent, not 60 per cent.

The truth is that we’re too small to figure largely in Trump’s thinking. And why kick the US lapdog we’ve made ourselves?

Trump has made much of his promise to deport the many millions of undocumented immigrants. Most of these people are doing jobs Americans don’t want to do. Getting rid of them would reduce the size of the economy while increasing inflation as employers offer higher wages to attract other people to unattractive jobs.

But not to worry. It’s hard to see just how he’d round up all these people without calling out the military. It’s much easier to see him limiting himself to trying harder to stop more people crossing the Mexican border. In this case, the reduction in the economy and the rise in costs would be smaller.

So far, his policies on tariffs and immigration seem likely to increase America’s rate of inflation while reducing its economic activity. Great idea. But then we come to his promises for big tax cuts.

He says he wants to cut the rate of company tax and “extend” his 2017 personal income tax cuts, which greatly favoured the high-income earners more likely to have been too smart to have voted for him.

In principle, you’d expect tax cuts to be expansionary and thus possibly inflationary. But note this: according to a strange American custom, the personal tax cuts enacted in 2017 are due to expire at the end of next year.

So extending them means not that everyone gets a tax cut, but everyone avoids a tax increase. The troops’ after-tax income is unchanged. But, of course, the budget deficit is now worse than previously projected.

One thing we can be sure of is that Trump’s not a man to worry about deficits and debt. Republican congresspeople do have a history of worrying about such matters – but only when those irresponsible Democrats are in charge.

The Yanks do have many of the smartest academic economists in the world and, as the US government’s annual interest payments get to be bigger than its spending on defence, they’re starting to wonder how long America’s fiscal insouciance can continue before something goes wrong. But the reckoning is unlikely to come in the next four years.

All told, it does seem that Trump’s policies will cause America’s inflation and interest rates to be higher than they would have been had Kamala Harris won the presidency. But what doesn’t follow is that this will have much effect on our inflation and interest rates, and on our Reserve Bank’s decision about when to start cutting rates to prevent us having an accidental recession.

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What goes on in the Reserve Bank's mind

By MILLIE MUROI, Economics Writer

So far, the Reserve Bank is winning. Every time we’ve had a new inflation read or jobs data, the country has held its breath … and exhaled a sigh of relief. Things are a little tougher for a lot of people, and a lot harder for some. But inflation, our public enemy number one, is gradually slinking away, and a historically high bunch of us have jobs.

The Reserve Bank might not be high-fiving itself yet, but it’ll be cautiously relieved that things are going (mostly) the way it planned. As the bank gets closer to the finish line, though, the balancing act will get harder. The reserve has been laser-focused on shrinking inflation, which it has. But the labour market is weakening, and there’s a risk we won’t feel or see the full impact on jobs of keeping interest rates on hold until after we’ve gone too far.

What is “too far”? Well, it’s tricky to say, because there’s no exact number to guide us on how many job losses we’d be OK with. And because – until we’ve locked inflation well within the 2 to 3 per cent target range – a strong jobs market is also a sign the economy might be pushing too hard to keep up with demand, and therefore that inflation might be here for a bit longer.

As one of the country’s leading labour economists, Jeff Borland, has pointed out, while recent data points to the Reserve Bank’s success so far, there probably needs to be a turning point in the bank’s thinking soon if we’re to avoid a big round of lay-offs.

Underlying inflation, the measure the bank cares about – and which doesn’t count items with especially large price changes – fell to 3.4 per cent over the year to August. Gross domestic product (a measure of how many goods and services the economy is producing), while crawling along, is still growing. And at 4.1 per cent in August, the unemployment rate shows we’ve managed to hold on to a lot of the gains in our labour market.

Compared with the US, UK and Canada, Australia seems to be the Goldilocks country. Partly because of Australia’s responsiveness to interest rate changes (we have one of the highest shares of mortgage-holders on variable rate loans, which means interest rate changes are felt pretty much immediately), the central bank has been less aggressive in ramping up interest rates to curb inflation.

While the US Federal Reserve jacked up rates by 5.3 percentage points from 2022 to its peak, Australian interest rates rose only 4.3 per cent (that’s also lower than in Canada and the UK). Despite this, the increase in Australia’s inflation rate since the first interest rate rise hasn’t strayed far from its peers. In fact, the 2.7 percentage point increase in inflation since the first rate rise is a lot lower than in the UK, where inflation surged 4.8 percentage points from its first rise.

The downward journey in inflation has also been fairly even across the countries. From its peak, Australia’s inflation rate has fallen about 0.7 percentage points every quarter, the same as in Canada and only a touch slower than the 0.8 percentage points in the US. The UK, with a high inflation peak, has had the fastest decline at 1 percentage point every quarter.

Australia’s approach has also limited damage to the jobs market. While unemployment increased 1.6 percentage points in Canada since the first rate rise and 0.8 percentage points in the US, the UK and Australia have managed to keep the lift in unemployment to just 0.6 percentage points.

At the same time, Australia’s participation rate has climbed 0.7 percentage points – the highest of its peers – since unemployment started rising. The participation rate is the proportion of working-age people (those aged over 16) who either have a job – full-time or part-time – or are actively seeking one (we call all these people “the labour force”) in the wider working-age population.

All this, together with high inflation, signals to the Reserve Bank that the Australian economy is still “running hot” as the Reserve’s chief economist Sarah Hunter has put it.

We tend to focus on the rate at which the economy is growing rather than the level it is sitting at. That’s why, when we see weak figures such as 0.2 per cent GDP growth for the most recent quarter (and for the quarter before that, and the one before that), we hear warning bells ringing about recession: commonly defined as two back-to-back quarters of falling growth.

So, why isn’t the bank in a rush to ease up on interest rates?

For as long as employment is growing and unemployment has risen only a bit, the bank won’t be living in fear, as many of its critics are, that the economy could drop into recession at any moment.

While the movement in GDP and household consumption has been very weak, the levels they’re at are still high – especially when compared with how much production capacity we have in the economy.

A strong labour market (one where most people who want a job can find one), means there’s still a lot of demand from businesses for workers. Why? Because there’s strong demand for their goods or services, and they need people to help produce or provide them. In August, for example, the Australian economy added more than 47,000 jobs.

But there are some signs the labour market is weaker than the headlines might tell us.

Some of the additional jobs and additional hours worked are a result of a big boost in immigration and therefore our population. In August, our population grew by 50,000 – but this growth won’t last forever, especially with the government’s cap on international students.

A lot of the growth in hours has also been in industries such as education, healthcare and social assistance. As Borland points out, about 40 per cent of the extra hours worked in recent months were in these largely government-funded industries – which, once again, cannot last forever.

We also know businesses are likely to be hoarding workers (firms tend to cling onto their workers when the economy starts to slow, until the very last minute, because it can be a pain to rehire them), and that interest rates take up to 12 to 18 months to impact the economy, meaning we may be yet to see the full impact of our rate rises.

Until underlying inflation sits comfortably within the target zone, GDP turns negative, or the jobs market deteriorates more noticeably, the Reserve Bank won’t be in a rush to dust off its bias towards reining in inflation.

But we know job loss has life-altering and long-lasting consequences for those affected. For the bank to keep Australia on the “narrow path” and continue to kill it (its job, that is, not the economy), it might need to start shifting its focus towards keeping us all in our jobs.

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All the reasons house prices will keep rising until we wake up

Contrary to popular opinion, the cost-of-living crisis will pass. But the housing crisis will go on worsening unless politicians – federal, state and local – try a mighty lot harder than they have been.

The cost of home ownership took off – that is, began rising faster than household incomes – about the time I became a journo 50 years ago, and is still going. Even the (unlikely) achievement of Anthony Albanese’s target of building 1.2 million new homes by 2029 probably wouldn’t do more than slow the rate of worsening affordability for a while.

You’d think there must be some kind of limit to how much harder it becomes to afford a home of your own, but considering how long it’s been running, it’s difficult to see just how it will come to an end.

It’s the advent of the Bank of Mum and Dad that’s making the rise in prices seem self-sustaining. Housing prices keep rising, but this makes the existing home owners wealthier, giving them greater wherewithal to help their kids afford the higher prices, which keeps those prices rising, rather than falling back to a level young people could afford without a special leg-up.

Small problem: we end up with a country divided between those born into the wealthy, home-owning class and those born into the class where generation after generation has never been able to afford to own the home they live in. Is that the Australia we want to live in?

How on earth did we allow housing prices to rise faster than household incomes for the past five decades, with little reason to hope this gap won’t get ever wider?

By allowing the slow but steady decline in the rate of home ownership – which began in the mid-1970s – to be a problem we’d worry about later. Or worse, to be a problem the politicians only pretended to care about.

I call this the Howard Effect. John Howard takes the credit because he’s the polly who most clearly hinted at the political class’s true lack of concern about declining home ownership.

He was always repeating the line that he had yet to meet a home owner who thought rising house prices were a bad thing. Get it? The number of happy home-owning voters far exceeded the number of unhappy young couples unable to join the club.

But the rise of the Bank of Mum and Dad has changed this calculus. It’s proof of home owners’ dawning realisation that rising house prices are a two-edged sword. They’re not a problem only if you don’t give a crap about your kids.

It’s probably housing’s big part in the cost-of-living crisis that’s finally broken the dam of politicians’ disinterest in housing affordability. What is of lasting significance about the Albanese government’s efforts to speed up the rate of home-building is its shift to seeing blockage on the supply side of the housing market as the key to progress.

Until now, those seeking to do something about the decline in home ownership have focused on the way special tax breaks and pension exemptions add unhelpfully to the demand for housing.

But the misguided notion that its plan to reform negative gearing and the capital gains tax discount played a significant part in Labor’s loss of the 2019 federal election put paid to demand-side solutions.

The great strength of Albanese’s plan is its focus on reforming local government planning and zoning restrictions on the supply of medium and high-density housing in our capital cities.

Tax and pension problems are the responsibility of the feds. Planning and zoning restrictions are the responsibility of the states. As ever, the only way for nationwide state-level problems to be fixed is for the feds to take the lead. And, as ever, the only way for the feds to get the states to make changes is to flash the federal chequebook.

The state governments – NSW in particular – are making genuine efforts to overcome the long-standing NIMBY resistance to higher-density housing.

Great. But if you think fixing the density problem will stop housing prices rising faster than household incomes, you’re deluding yourself. Just as fixing negative gearing wasn’t a magic answer, nor is fixing density.

No problem as big and long-lasting as declining home ownership could be anything other than multi-faceted. Yes, we need to fix the supply side. But yes, we need to fix the demand side as well. And there’s more to the supply side than density, just as there’s more to the demand side than negative gearing.

Last week’s report of its Review of Housing Supply Challenges, by the NSW Productivity Commission, should be read by people in all states.

The report says local councils should lift their game in reducing the inordinate delays in accepting development approvals and in reducing unreasonable demands on builders.

I think government agencies are monopolies and, like all monopolies, they rarely resist the temptation to put their own convenience ahead of their customers’ needs.

As federal Treasury’s sermon on the housing challenge in this year’s budget papers also made clear, the NSW report notes that part of the problem is the inadequacy and inflexibility of our housing industry.

It’s simply not capable of expanding to meet the surge in demand for homes – something that, I suspect, doesn’t worry it greatly. It’s content to respond by “rationing by [higher] price”, a mechanism I explained in last week’s column.

But the NSW report says the housing industry simply doesn’t have enough tradespeople to increase its production. Workers have been lost to the major construction projects, thanks to the surge in state government spending on infrastructure.

This is no doubt right, as far as it goes. It’s certainly true that state governments would do better (and cheaper) if they timed their investment spending to fit with the ups and downs of private sector major construction spending.

But I think the ability to meet shortages of skilled workers simply by bringing workers from overseas when you need them has led the industry to neglect training sufficient apprentices to meet future needs.

Neither this report nor Treasury’s budget sermon acknowledges another possible supply-side problem, the one highlighted by the economists’ great alternative thinker on housing, Dr Cameron Murray. He argues that the developers keep house prices rising by limiting the release of land to fit.

When you look at the broader causes of ever-rising house prices, even the Reserve Bank doesn’t escape responsibility. The central bankers have always argued that housing prices are a consequence of the interaction of the demand for housing and its supply, so nothing to do with them.

Again, that’s true as far as it goes. But it sidesteps the more behavioural possibility that whacking interest rates up and down engenders an “irrational” FOMO – fear of missing out – that helps keep house prices rising when rates are falling and even when rates are rising and could rise further.

If so, that’s yet another reason why the economists need to come up with a better way of limiting demand than just screwing young people with big mortgages.

There’s more to ever-rising house prices than has ever crossed the minds of most economists.

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If there's no 'price gouging' how come interest rates are so high?

The nation’s economists have a dirty little secret. They all believe that what the punters denigrate as “price gouging” is actually a good thing, part of the mechanism by which a market economy returns to “equilibrium” (balance) after it’s been hit by an inflationary shock.

But they have a visceral hatred of terms such as “price gouging” and “profiteering”, and are always producing graphs and calculations purporting to prove that the recent surge in inflation – the worst in about 40 years – has produced no increase in company profits.

What they don’t seem to have noticed, however – or maybe are hoping none of us have noticed – is that you can’t argue that demand has been growing stronger than supply and so causing price increases, thus justifying using higher interest rates to slow down demand, and at the same time claim there’s no evidence that profits have risen.

Sorry, guys. You can’t have it both ways. If you claim there’s been no noticeable rise in profits, you’re contradicting the Reserve Bank’s main justification for its 13 increases in the official interest rate since May 2022. (Which is funny, considering the Reserve has been prominent among those seeking to deny that profits have risen.)

That main justification has been that much of the worsening in the rate of price increases has been caused by “excessive demand”, thus necessitating higher interest rates to discourage us from spending so much.

But how exactly does excessive demand lead to higher prices? It’s simple. When there are more people wanting to buy my product than I and my suppliers can keep up with, I could leave the price I’m charging unchanged, in which case it won’t be long before my shelves are empty, and I have nothing to sell.

That’s not the way it works in practice, however, nor the way it works in economic theory. I take advantage of strong demand to raise the price at which I’m selling the item. Why do I do this? Because, like all business people, I’m trying to maximise my profit.

The higher price means I won’t be selling my stock as fast as I was – so it will take longer for my shelves to empty – but I’ll still be better off.

Economists say that when demand exceeds supply, the stuff still available has to be rationed, one way or another. One way to ration supply is simply to keep selling at an unchanged price until everything is sold. After that, everyone who comes later misses out.

But when the seller raises their price, economists call this “rationing by [higher] price”. They believe this is always the better solution to the rationing problem because it does so in a way that uses the “market mechanism” to fix the problem.

The higher price encourages would-be buyers to reduce their demand – by wasting less of the product, or finding a cheaper substitute – while encouraging suppliers to produce more of the now-more-profitable product.

So because the higher price reduces demand while increasing the supply, the price mechanism causes the price of the item to fall back towards what it first was. Brilliant. Another win for market forces.

But this means a (possibly temporary) rise in prices is an essential part of the price mechanism. So a consequent rise in profits is also an inevitable part of the mechanism.

It’s gone out of fashion but, long ago, economists would say there were two causes of inflation: “cost-push” and “demand-pull”.

Sometimes firms raise their prices because they’re passing on the higher costs they’re paying for their inputs. At other times they’re raising their prices simply because the high demand for their product allows them to.

We now know from the work of behavioural economists that ordinary consumers accept it’s OK for businesses to raise their prices because of their higher costs. But they regard raising your prices just because shortages in supply let you get away with it as exploitative. (The classic example is charging more for umbrellas on rainy days.)

This dual, supply caused and demand-caused, explanation for inflation fits well with the Reserve’s analysis of the origins of the great surge in prices – in all the developed economies – in late 2021 and 2022.

Part of it was from disruptions to supply caused mainly by the COVID-19 pandemic, but also the Ukraine war, which pushed up the cost of building materials, various manufactured goods, shipping and oil and gas. But part of it was caused by the excessive stimulus applied to the economy by governments and central banks during the pandemic and its lockdowns, which had caused the demand for goods and services to run ahead of the economy’s ability to produce them.

Increasing interest rates can do nothing to increase supply, and the end of the lockdowns would see supply gradually return to normal, the Reserve reasoned. But higher rates could dampen the excess demand caused by all the extra government spending and rock-bottom interest rates that was applied to ensure the lockdowns didn’t lead to a lasting recession.

See how this analysis is undermined by claims there’s no sign of firms earning higher profits in the post-pandemic period? It implies that there’s no sign of excess demand, suggesting the surge in prices must have come only from supply disruptions and other cost increases.

In which case, the justification for maintaining high interest rates is greatly weakened. It implies that demand hasn’t been growing excessively and, rather than waiting for the supply problems to resolve themselves, we’re going to batter down demand to fit.

If so, that would be a very painful solution to a temporary problem. And, unlike the inflation problem we suffered in the 1970s, there’s no way this inflation surge can be blamed on excessive growth in wage costs.

Real wage growth had been weak long before the pandemic arrived. And in 2020, many workers were persuaded to skip an annual wage rise in the belief that we’d entered a lasting recession. As we subsequently discovered, government handouts to business meant many businesses sailed through the pandemic with few scratches.

Why so many economists want us to believe that, despite decades of increased market concentration – more industries dominated by just a few huge firms – and despite excessive monetary and budgetary stimulus, profits never increase, I’m blowed if I know.

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RBA worries too much about expectations of further high inflation

Other central banks have started cutting interest rates, yet our Reserve Bank is declining to join them because, as governor Michele Bullock explained on Friday, it doesn’t expect our rate of inflation to fall back to the mid-point of its target range “in a reasonable timeframe”.

Its latest forecasts don’t see the “underlying” (that is, smoothed) annual inflation rate returning to 3 per cent until the end of next year, and reaching the mid-point of 2.5 per cent until late in 2026.

Clearly, the Reserve doesn’t see such a timeframe as reasonable, so it’s keeping interest rates high for longer, until it can see inflation returning to target much earlier. And, Bullock warns, should the inflation outlook get worse, she won’t hesitate to raise rates further.

Obviously, the longer interest rates stay high, the greater the risk of forcing the economy into recession, with much higher unemployment and business failures, something Bullock swears she wants to avoid.

But what’s the hurry? Why is taking another two years to get inflation down an unreasonable timeframe? (Another question is, what’s so magical about 2.5 per cent? Why would 3 per cent or 3.5 per cent also be unreasonable? But I’ll leave that for another day.)

The hurry comes from central bankers’ longstanding fear that, should the inflation rate stay high for too long, the people who set prices and wages will come to expect that inflation will stay high rather than return to where it used to be.

Why do their expectations matter? Because, many economists believe, when enough people expect inflation to stay high, they act on their expectations and so make them a reality. Workers and their unions demand higher wages, and businesses pass their higher costs on to customers in higher prices.

This is the much-remarked “wage-price spiral”. It’s important to remember, however, that inflation expectations and wage-price spirals aren’t a longstanding tenet of either neoclassical or Keynesian economics.

They’re just a bit of pop psychology some economists came up with to explain why, in the mid-1970s, the developed economies found themselves beset by “stagflation” – both high inflation and high unemployment.

So how much we should worry about inflation expectations is an empirical question: is the idea borne out by the facts and figures?

In 2022, Dr John Bluedorn and colleagues at the International Monetary Fund conducted a study of the historical evidence for wage-price spirals in the developed economies, concluding that a jump in wage growth shouldn’t necessarily be seen as a sign that a wage-price spiral is taking hold.

Bluedorn elaborated on these finding at the Reserve Bank’s annual research conference last September. The discussant for his paper was Iain Ross, former president of the Fair Work Commission and now a member of the Reserve’s board.

Ross (and leading labour market economists, such as Melbourne University’s Professor Jeff Borland) readily agree that Australia experienced a wage-price spiral in the 1970s. But both men conclude that our circumstances 50 years later are “very different”, which means it should be possible to sustain steady wage growth without initiating a wage-price spiral.

In mid-2022, Borland listed three respects in which our present circumstances are different. First, upward pressure on wages is being limited on the supply side by employers’ ability to give extra hours of work to part-time workers who’d prefer more hours, and by drawing more participants into the jobs market.

Second, changes in the “institutional environment” since the 1970s have reduced the scope for people to get wage rises based on the principle of “comparative wage justice” – “Those workers have had a pay rise, so it’s only fair that we get the same.”

And third, a decline in the proportion of workers who are members of a union, and a range of other factors, have reduced workers’ bargaining power, thus limiting the size of wage increases likely to be obtained.

There could hardly be anyone in the country better qualified than Ross to explain how the institutional arrangements governing the way wages are set have changed over the decades. He told the conference that “these changes have been profound and substantially reduce the likelihood of a wage-price spiral”.

The central difference was that, in the 1970s and 1980s, the institutional arrangements facilitated the transmission of wage increases bargained at the enterprise level – usually by unions in the metal trades – to the relevant industry sector and then ultimately to the broader workforce.

There were four important respects in which the present rules are very different. First, the new “modern awards” operate as a minimum safety net and the circumstances in which minimum wages may be adjusted are limited. In effect, there is no scope to adjust minimum award rates to reflect the outcome of collective bargaining at the enterprise level.

Second, the Fair Work Act limits the general adjustment of all modern-award minimum wage rates to one annual wage review conducted by the Fair Work Commission.

Third, enterprise agreements need to be approved by the commission before they acquire legal force. The length of agreements averages three years, during which time employees covered by that agreement can’t lawfully engage in industrial action in pursuit of further wage rises.

Fourth, the sanctions against engaging in such industrial action are, Ross said, “readily accessible and effective”.

Ross noted that the proportion of all workers who are members of a union has fallen dramatically since the 1970s. From a little above 50 per cent, it has fallen to 12.5 per cent. And in the private sector it’s down to 8.2 per cent.

The manufacturing sector and its unions were central to the wage-price spiral of the 1970s. But manufacturing’s share of total employment has fallen from 22 per cent to 6 per cent, while the proportion of union members in manufacturing has fallen from 57 per cent to 10 per cent.

Whereas the annual number of working days lost to industrial disputes was about 800 per 1000 employees during the 1970s, these days it’s next to nothing.

Ross said the present enterprise bargaining arrangements operate as a shock absorber by constraining the bargaining capacity of employees subject to an agreement. “To date there is no evidence of the emergence of a wage-price spiral in the present circumstances and recent data suggests such an outcome is unlikely,” he concluded.

My point is, there’s no reason for the Reserve to live in fear of an imminent worsening in inflation expectations if workers and their unions’ ability to turn their expectations into higher wages is greatly constrained. That being so, we shouldn’t allow impatience to get the inflation rate back to target to worsen the risk we’ll end up in a recession, the depth and length of which could greatly impair our return to full employment.

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Cost-of-living crisis? Why only some of us are feeling the pinch

If you believe the opinion polls, we’re all groaning under the weight of the cost-of-living crisis. And Treasurer Jim Chalmers confirms we’ve all been “under the pump”. But it’s not that simple. Some of us are doing it a lot tougher than others. And some of us are actually ahead on the deal.

In any case, where did the living-cost crisis come from? That bit’s simple. The economy’s been on a rollercoaster for the past four and a half years. COVID and the lockdowns may seem a distant memory, but almost everything that’s happened in the economy since the end of 2019 has been the direct or indirect consequence of the pandemic.

The surge in consumer prices that began in early 2022 stemmed from a combination of temporary disruptions to supply caused by the pandemic, and excess demand for goods and services as people spent the money they’d earned but couldn’t spend during the lockdowns.

The tax cuts that began this month had been planned for six years, but Chalmers changed their intended shape radically to help people most affected by the cost of living. They mean that, by the end of this year, overall living standards should be just a little up on where they were five years ago.

Just as the media focus on bad news more than good news, so you and I focus more on what’s been happening to the cost of living than what’s been happening to our after-tax income. But it’s the difference between the two – our standard of living – that matters most.

Two economists at the Australian National University’s Centre for Social Policy Research, Associate Professor Ben Phillips and Professor Matthew Gray, have been crunching the numbers, and their results may surprise you.

They’ve examined the change in our standard of living since the end of 2019, and included a forecast up to the end of this year, to take account of the latest tax cuts and changes in the May budget.

Lumping all households together, they find that we did quite well in 2020 and 2021 as the Reserve Bank cut interest rates and governments spent billions on such things as the JobKeeper scheme and temporary doubling of JobSeeker unemployment benefits. But then living standards fell sharply in 2022 as consumer prices took off and housing costs rose. Living standards fell a little further last year, taking them to 0.6 per cent lower than they were before COVID arrived.

The authors estimate that, this year, the tax cuts and continuing pay rises will lift living standards to a princely 1.6 per cent above what they were in December 2019.

But those national averages conceal much variation. When the authors ranked all households by their disposable income, then divided them into five “quintiles”, the poorest 20 per cent are expected to end the five years with their living standard 3.5 per cent higher.

Huh? They did well partly because their pensions and benefits are indexed to inflation.

At the same time, the top 20 per cent of households are expected to be 2.7 per cent ahead. Why? Partly because they did well on their investments.

So it’s the middle 60 per cent of households that have been hit the hardest by the cost of living. The second lowest 20 per cent barely broke even, while the middle and upper-middle quintiles suffered a fall in their living standards.

But now we get to the pointy bit. Why did the middle do so much worse than the rest? Because that’s where you find most of the people with mortgages. Turns out all those households with mortgages are expected to see their living standards fall by 5.6 per cent over the five years to December 2024.

What about renters? Their living standards should rise by 2.9 per cent over the period. Huh? How could that be? It’s true that shortages of rental accommodation have caused rents to rise hugely this year and last. But much of that can be seen as catch-up for the lockdown-caused falls in rents in 2020 and 2021, and the small increases in 2022.

If you’re sitting down, I’ll tell you that the living standards of people who own their homes outright are expected to rise by … 8.5 per cent.

But here’s an even bigger shock: if you divide all the households by their main source of income, those in the “other” category – that is, not reliant on either wages or pensions – should see their standard of living rise by what the authors call “an astounding 15.8 per cent”.

Penny dropped yet? Yes, we’re talking about the group that always has its hand out for a handout to thank it for being too well-off to get the age pension: the self-described, so-called self-funded retirees.

But while you’re feeling sorry for all those poor souls (whose company I’ll be joining one day), spare a kick for the economists who, several decades ago, had the bright idea of using only interest rates to control inflation. They must have had a fairness bypass.

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Interest rate speculators should get back in their box

There’s nothing the financial markets and the media enjoy more than speculating about the future of interest rates. And with last week’s news that consumer prices rose by 4 per cent over the year to May, they’re having a field day.

Trouble is, the two sides of the peanut gallery tend to egg each other on. They have similar ulterior motives: the money market players lay bets on what will happen, while the media can’t resist a good scare story – even one that turns out to have scared their customers unnecessarily, thus eroding their credibility.

But the more the two sides work themselves up, the greater the risk they create such strong expectations of a rate rise that the Reserve Bank fears it will lose credibility as an inflation fighter unless it acts on those expectations.

Fortunately, the Reserve’s newly imported deputy governor, Andrew Hauser, has put the speculators back in their box with his statement that “it would be a bad mistake to set policy on the basis of one number, and we don’t intend to do that”.

He added that there was “a lot to reflect on” before the Reserve board next meets to decide interest rates early next month. Just so. So, let’s move from idle speculation to reflection.

For a start, we should reflect on the wisdom of the relatively recent decision to supplement the quarterly figures for the consumer price index with monthly figures.

This has proved an expensive disaster, having added at least as much “noise” as “signal” to the public debate about what’s happening to inflation. Why? Because many of the prices the index includes aren’t actually measured monthly.

Many are measured quarterly, and some only annually. In consequence, the monthly results can be quite misleading. Do you realise that, at a time when we’re supposedly so worried that prices are rising so strongly, every so often the monthly figures tell us prices overall have fallen during the month?

In an ideal world, the people managing the macroeconomy need as much statistical information as possible, as frequently as possible. But in the hugely imperfect world we live in, paying good taxpayers’ money to produce such dodgy numbers just encourages the speculators to run around fearing the sky is falling.

The Reserve has made it clear it’s only the less-unreliable quarterly figures it takes seriously but, as last week reminded us, that hasn’t stopped the people who make their living from speculation.

The next thing we need to reflect on is that our one great benefit from the pandemic – our accidental return to full employment after 50 years wandering in the wilderness – has changed the way our economy works.

I think what’s worrying a lot of the people urging further increases in interest rates is that, as yet, they’re not seeing the amount of blood on the street they’re used to seeing. Why is total employment still increasing? Why isn’t unemployment shooting up?

One part of the answer is that net overseas migration is still being affected by the post-pandemic reopening of our borders – especially as it affects overseas students – which means our population has been growing a lot faster than has been usual after more than a year of economic slowdown.

But the other reason the labour market remains relatively strong is our return to full employment and, in particular, the now-passed period of “over-full employment” – with job vacancies far exceeding the number of unemployed workers.

With the shortage of skilled workers still so fresh in their mind, it should be no surprise that employers aren’t rushing to lay off workers the way they did in earlier downturns. As we saw during the global financial crisis of 2008-09, they prefer to reduce hours rather than bodies.

It’s the changing shares of full-time and part-time workers – and thus the rising rate of underemployment – that become the better indicators of labour market slack in a fully employed economy.

The other thing to remember is the Albanese government’s resolve not to let the ups and downs of the business cycle stop us from staying close to the full employment all economists profess to accept as the goal macroeconomic management.

This resolve is reflected in the Reserve Bank review committee’s recommendation that the goal of full employment be given equal status with price stability, which the Reserve professes to have accepted.

This doesn’t mean the business cycle has been abolished, nor that the rate of unemployment must never be allowed to rise during a period in which we’re seeking to regain control over inflation.

What it does mean is that we can’t return to the many decades where the commitment to full employment was merely nominal, and central banks and their urgers found it easier to meet their inflation targets by running the economy with permanently high unemployment.

The financial markets may persist in their view that high inflation matters and high unemployment doesn’t, but that shouldn’t leave them surprised and dissatisfied with a central bank that’s not whacking up interest rates with the gay abandon they’ve seen in previous episodes.

But there’s one further issue to reflect on. It’s former Reserve Bank governor Dr Philip Lowe’s prediction in late 2022 that we’d be seeing “developments that are likely to create more variability in inflation than we have become used to”. As someone put it: shock after shock after stock.

The point is, it’s all very well for people to say we should keep raising interest rates until the inflation rate is down to 2 per cent or so, but what if price rises are being caused by problems on the supply (production) side of the economy, not by excessive demand?

High interest rates have already demonstrated their ability to end excessive demand, as quarter after quarter of weak consumer spending, and a collapse in the rate of household saving, bear witness. But if high prices are coming from factors other than excess demand, there’s nothing an increase in interest rates can do to fix the problem.

What surprises me is how little attention market economists have been paying to what’s causing the seeming end to the inflation rate’s fall to the target range.

Look at the big price increases that have contributed most to the 4 per cent rise over the year to May – in rents, newly built homes, petrol, insurance, alcohol and tobacco – and what you don’t see is booming demand.

Right now, all we can do to push inflation down is attempt to hide the effect of supply-side problems on the price index by putting the economy into such a deep recession that other prices are actually falling.

This was never a sensible idea, and it’s now ruled out by the government and the Reserve’s commitment never to stray too far from full employment.

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The RBA has squeezed us like a lemon, but it's still not happy

Let me be the last to tell you the economy has almost ground to a halt and is teetering on the edge of recession. This has happened by design, not accident. But it doesn’t seem to be working properly. So, what happens now? Until we think of something better, more of the same.

Since May 2022, the Reserve Bank has been hard at work “squeezing inflation out of the system”. By increasing the official interest rate 4.25 percentage points in just 18 months, it has produced the sharpest tightening of the interest-rate screws on households with mortgages in at least 30 years.

To be fair, the Reserve’s had a lot of help with the squeezing. The nation’s landlords have used the shortage of rental accommodation to whack up rents.

And the federal government’s played its part. An unannounced decision by the Morrison government not to continue the low- and middle-income tax offset had the effect of increasing many people’s income tax by up to $1500 a year in about July last year. Bracket creep, as well, has been taking a bigger bite out of people’s pay rises.

With this week’s release of the latest “national accounts”, we learnt just how effective the squeeze on households’ budgets has been. The growth in the economy – real gross domestic product – slowed to a microscopic 0.1 per cent in the three months to the end of March, and just 1.1 per cent over the year to March. That compares with growth in a normal year of 2.4 per cent.

This weak growth has occurred at a time when the population has been growing strongly, by 0.5 per cent during the quarter and 2.5 per cent over the year. So, real GDP per person actually fell by 0.4 per cent during the quarter and by 1.3 per cent during the year.

As the Commonwealth Bank’s Gareth Aird puts it, the nation’s economic pie is still expanding modestly, but the average size of the slice of pie that each Australian has received over the past five quarters has progressively shrunk.

But if we return to looking at the whole pie – real GDP – the quarterly changes over the past five quarters show a clear picture of an economy slowing almost to a stop: 0.6 per cent, 0.4 per cent, 0.2 per cent, 0.3 per cent and now 0.1 per cent.

It’s not hard to determine what part of GDP has done the most to cause that slowdown. One component accounts for more than half of total GDP – household consumption spending. Here’s how it’s grown over the past six quarters: 0.8 per cent, 0.2 per cent, 0.5 per cent, 0.0 per cent, 0.3 per cent and 0.4 per cent.

A further sign of how tough households are doing: the part of their disposable income they’ve been able to save each quarter has fallen from 10.8 per cent to 0.9 per cent over the past two years.

So, if the object of the squeeze has been to leave households with a lot less disposable income to spend on other things, it’s been a great success.

The point is, when our demand for goods and services grows faster than the economy’s ability to supply them, businesses take the opportunity to increase their prices – something we hate.

But if we want the authorities to stop prices rising so quickly, they have only one crude way to do so: by raising mortgage interest rates and income tax to limit our ability to keep spending so strongly.

When the demand for their products is much weaker, businesses won’t be game to raise their prices much.

So, is it working? Yes, it is. Over the year to December 2022, consumer prices rose by 7.8 per cent. Since then, however, the rate of inflation has fallen to 3.6 per cent over the year to March.

Now, you may think that 3.6 per cent isn’t all that far above the Reserve’s inflation target of 2 per cent to 3 per cent, so we surely must be close to the point where, with households flat on the floor with their arms twisted up their back, the Reserve is preparing to ease the pain.

But apparently not. It seems to be worried inflation’s got stuck at 3.6 per cent and may not fall much further. In her appearance before a Senate committee this week, Reserve governor Michele Bullock said nothing to encourage the idea that a cut in interest rates was imminent. She even said she’d be willing to raise rates if needed to keep inflation slowing.

It’s suggested the Reserve is worried that we have what economists call a “positive output gap”. That is, the economy’s still supplying more goods and services than it’s capable of continuing to supply, creating a risk that inflation will stay above the target range or even start going back up.

With demand so weak, and so many people writhing in pain, I find this hard to believe. I think it’s just a fancy way of saying the Reserve is worried that employment is still growing and unemployment has risen only a little. Maybe it needs to see more blood on the street before it will believe we’re getting inflation back under control.

If so, we’re running a bigger risk of recession than the Reserve cares to admit. And if interest rates stay high for much longer, I doubt next month’s tax cuts will be sufficient to save us.

Another possibility is that what’s stopping inflation’s return to the target is not continuing strong demand, but problems on the supply side of the economy – problems we’ve neglected to identify, and problems that high interest rates can do nothing to correct.

Problems such as higher world petrol prices and higher insurance premiums caused by increased extreme weather events.

I’d like to see Bullock put up a big sign in the Reserve’s office: “If it’s not coming from demand, interest rates won’t fix it.”

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RBA will decide how long the economy's slump lasts

The media are always setting “tests” that the government – or the opposition – must pass to stay on top of its game. But this year, it’s the Reserve Bank facing a big test: will it crash the economy in its efforts to get inflation down?

There’s a trick, however: when the Reserve stuffs up, it doesn’t pay the price, the elected government does. This asymmetry is the downside of the modern fashion of allowing central banks to be independent of the elected government. Everything’s fine until the econocrats get it badly wrong.

It’s clear from last week’s national accounts that the economy has slowed to stalling speed. It could easily slip into recession – especially as defined by the lightweight two-successive-quarters-of-negative-growth brigade – or, more likely, just go for a period in which the population keeps growing but the economy, the real gross domestic product, doesn’t, and causes unemployment to keep rising.

Because interest rates affect the economy with a lag, the trick to successful central banking is to get your timing right. If you don’t take your foot off the brake until you see a sign saying “inflation: 2.5 per cent”, you’re bound to run off the road.

So now’s the time to think hard about lifting your foot and, to mix the metaphor, ensuring the landing is soft rather than hard.

Here’s a tip for Reserve Bank governor Michele Bullock. If you get it wrong and cause the Albanese government to be tossed out in a year or so’s time, two adverse consequences for the Reserve would follow.

First, it would be decades before the Labor Party ever trusted the Reserve again. Second, the incoming Dutton government wouldn’t feel a shred of secret gratitude to the Reserve for helping it to an undeserved win. Rather, it would think: we must make sure those bastards in Martin Place aren’t able to trip us up like they did Labor.

Last week’s national accounts told us just what we should have expected. They showed that real GDP – the nation’s total production of goods and services – grew by a negligible 0.2 per cent over the three months to the end of December.

This meant the economy grew by 1.5 per cent over the course of 2023. If that looks sort of OK, it isn’t. Get this: over the past five quarters, the percentage rate of growth has been 0.8, 0.6, 0.5, 0.3 and 0.2. How’s that for a predictable result?

Now you know why, just before the figures were released, Treasurer Jim Chalmers warned that we could see a small negative. It’s a warning we can expect to hear again this year.

If you ignore the short-lived, lockdown-caused recession of 2020, 1.5 per cent is the weakest growth in 23 years.

But it’s actually worse than it looks. What measly growth we did get was more than accounted for by the rapid, post-COVID growth in our population. GDP per person fell in all four quarters of last year.

So whereas real GDP grew by 1.5 per cent, GDP per person fell by 1 per cent. We’ve been in a “per-person recession” for a year.

It’s not hard to see where the weaker growth in overall GDP is coming from. Consumer spending makes up more than half of GDP, and it grew by a mere 0.1 per cent in both the December quarter and the year.

At a time when immigration is surging, and it’s almost impossible to find rental accommodation, spending on the building of new homes fell by more than 3 per cent over the year.

Of course, this slowdown is happening not by accident, but by design. Demand for goods and services had been growing faster than the economy’s ability to supply them, permitting businesses of all kinds to whack up their prices and leaving us with a high rate of inflation.

Economists – super-smart though they consider themselves to be – have been able to think of no better way to stop businesses exploiting this opportunity to profit at the expense of their customers than to knock Australia’s households on the head, so they can no longer spend as much.

For the past several decades, we’ve done this mainly by putting up interest rates, so people with mortgages were so tightly pressed they had no choice but to cut their spending. The Reserve began doing this during the election campaign in May 2022, and did it again 12 more times, with the last increase as recently as last November.

It would be wrong, however, to give the Reserve all the credit – or the blame – for the 12 months of slowdown we’ve seen. It’s had help from many quarters. First is the remarkable rise in rents, the chief cause of which is an acute shortage of rental accommodation, affecting roughly a third of households.

Next are the nation’s businesses which, in their zeal to limit inflation, have raised their wages by about 4.5 percentage points less than they’ve raised their prices. Talk about sacrifice.

And finally, there’s the federal government, which has done its bit by restraining its spending and allowing bracket creep to claw back a fair bit of the inflation-caused growth in wage rates. As a consequence, the budget has swung from deficit to surplus, thereby helping to restrain aggregate demand.

It’s the help the Reserve has had from so many sources that risks causing it to underestimate the vigour with which spending is now being restrained. It’s far from the only boy standing on the burning deck.

Last week some were criticising the Reserve for popping up in November, after doing nothing for five months, and giving the interest-rate screws another turn while, as we now know, the economy was still roaring along at the rate of 0.2 per cent a quarter.

The critics are forgetting the politics of economics. That isolated tightening was probably the new governor signalling to the world that she was no pushover when it came to the Reserve’s sacred duty to protect us from inflation.

In any case, a rate rise of a mere 0.25 per cent isn’t much in the scheme of things. It’s possible that quite a few hard-pressed home buyers felt the extra pain. But when did anyone ever worry about them and their pain? It was the central bankers’ duty to sacrifice them to the economy’s greater good – namely, preventing the nation’s profit-happy chief executives from doing what comes naturally to all good oligopolists.

The looming stage 3 tax cuts should give a great boost to the economy, of course, provided seriously rattled families don’t choose to save rather than spend them.

What matters most, however, is by how much unemployment and underemployment rise before the economy resumes firing on all cylinders. So far, the rate of unemployment has risen to 4.1 per cent from its low of 3.5 per cent in February last year.

By recent standards, that’s still an exceptionally low level, and a modest increase in the rate. But for a more definitive assessment, come back this time next year.

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Contrary to appearances, the stage 3 tax cuts will leave us worse off

It’s time we stopped kidding ourselves about the looming tax cuts. They’re what you get when neither of the two big parties is game to make real tax reforms, and the best they can do is lumber us with yet another failed attempt to wedge the other side.

If you want real reform, vote for the minor parties, which may be able to use their bargaining power in the Senate to get something sensible put through.

The stage 3 tax cuts always were irresponsible, and still are. They’ve caused interest rates to be raised by more than they needed to be, and they’ll leave us with substandard government services, as well as plunging us back into deficit and debt.

Only an irresponsible (Coalition) government would commit themselves to making a huge tax cut of a specified shape more than six years ahead of an unknowable future, hoping they could trick Labor into making itself an easy political target by opposing them.

Back then, the Libs thought the budget was returning to continuing surpluses. Wrong. They didn’t think there’d be a pandemic. Wrong. They had no idea it would be followed by an inflation surge and a cost-of-living crisis.

Only an irresponsible (Labor) opposition would go along with legislating the tax cuts five years ahead of time, then promise not to change them should it win the 2022 election.

Let’s be clear. Just because Prime Minister Anthony Albanese’s changes made the tax cuts less unfair, that doesn’t make them good policy. And just because many families, hard-pressed by the cost-of-living crisis, will be pleased to have the relief the tax cuts bring, that doesn’t mean the tax cuts are now good policy.

Don’t be misled by the Reserve Bank’s acceptance of Albanese’s claim that his changes would not add to inflation. Any $20 billion-a-year tax cut is a huge stimulus to demand, imparting further upward pressure on prices.

All the Reserve was saying was that diverting a lump of the tax cut from high-income earners to middle and low earners wouldn’t make much difference to the degree of stimulus. Why wasn’t it worried about a $20 billion inflationary stimulus? Because it had known it was coming for years, and had already taken account of it, increasing interest rates sufficiently to counter its future inflationary effect.

Get it? Had there been no huge tax cut in the offing, interest rates would now be lower than they are, and causing less cost-of-living pain.

As the Grattan Institute’s Brendan Coates and Kate Griffiths have reminded us, the big loser from the stage 3 tax cuts – whether the original or the revised version – is the budget.

The budget has done surprisingly well from the return to full employment, the effect of continuing high commodity prices on miners’ payments of company tax and from wage inflation’s effect on bracket creep. So much so that it returned to a healthy surplus last financial year. It may well stay in surplus this financial year.

Great. But next year it’s likely to return to deficit and stay there for the foreseeable future. Why? Because we can’t afford to give ourselves a $20 billion annual tax cut at this time. As if we didn’t have enough debt already, we’ll be borrowing to pay for our tax cut.

In theory, of course, we could pay for it with a $20 billion-a-year cut in government spending. But, as the Coalition was supposed to have learnt in 2014 – when voters reacted badly to its plans for big spending cuts, and it had to drop them post-haste – this is a pipe dream.

No, in truth, what voters are demanding is more spending, not less. The previous government went for years using fair means or foul – robo-debt, finding excuses to suspend people’s dole payments, neglecting aged care, allowing waiting lists to build up – to hold back government spending as part of its delusional claim to be able to reduce taxes.

As Dr Mike Keating, a former top econocrat, has said, we keep forgetting that the purpose of taxation is to pay for the services that our society demands, and which are best financed collectively.

So when we award ourselves a tax cut we can’t afford, the first thing we do is condemn ourselves to continuing unsatisfactory existing services, and few of the additional services we need.

Those additional services include education – from early education to university – healthcare, childcare, aged care, disability care and defence. (Another thing the Libs didn’t foresee in 2018: our desperate need to acquire nuclear subs.)

But don’t hold your breath waiting for any politician from either major party to explain that home truth to the punters. No, much better to keep playing the crazy game where the Libs unceasingly claim to be the party of “lower, simpler and fairer taxes” and Labor says “I’ll see you and raise you”.

Anyone who knows the first thing about tax reform knows that achieving that trifecta is impossible. But if the Liberal lightweights realise how stupid repeating that nonsense makes them seem to the economically literate, they don’t care.

All they know is that the punters lap up that kind of self-delusion. Which, of course, is why Labor never calls them out on their nonsense.

The other thing we do by pressing on with tax cuts we can’t afford is sign up for more deficits and debt. Coates and Griffiths remind us that the high commodity prices the budget is benefitting from surely can’t last forever.

If you exclude this temporary benefit, Grattan estimates that we’re running a “structural” budget deficit of close to 2 per cent of gross domestic product, or about $50 billion a year in today’s dollars.

We’re ignoring it now, but one day we’ll have to at least start covering the extra interest we’ll be paying. How? By increasing taxes. How else? Ideally, we’d introduce new taxes that improved our economic efficiency or the system’s fairness. Far more likely, we’ll just be given back less bracket creep.

It’s the pollies’ bipartite policy of not stopping bracket creep by indexing the income tax scales each year that makes their unceasing talk of lower tax so dishonest and hypocritical. They’ve demonised all new taxes or overt increases in existing taxes, while keeping bracket creep hidden in their back pocket.

Which is not to argue we must eradicate it. Most of the tax reform we’ve had – notably, the introduction of the goods and services tax – has come with the political sweetener of a big, bracket-creep-funded cut in income tax. (Would-be reformers, please note.)

Another name for bracket creep is “automatic stabiliser”. When spending is growing strongly and inflation pressure is building, bracket creep is one of the budget’s main instruments working automatically to help restrain demand by causing people’s after-tax income to rise by a lower percentage than their pre-tax income.

The pollies can’t just let bracket creep roll on for forever. You have to use the occasional tax cut to return some of the proceeds. But July 2024 turned out to be quite the wrong time to do it.

So even if the Reserve starts to cut interest rates towards the end of this year, the tax cuts mean rates will stay higher for longer than they needed to.

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How full employment has changed the economy

This may be the first time you’ve watched the managers of the economy using high interest rates and a tighter budget to throttle demand to get inflation down. But if it isn’t your first, have you noticed how much harder they’re finding it to catch the raging bull?

It explains why both the previous and the new Reserve Bank governor have been so twitchy. How, after they seem to have made as many interest rate rises as they thought they needed, they keep coming back for another one.

The economy isn’t working the way it used to. Have you noticed that, although consumer spending stopped dead in the September quarter, and overall growth in the economy slowed to a microscopic 0.2 per cent, there’s been so little weakness in the jobs market?

Although there’s no doubt about how hard most households have been squeezed over the course of this year, how come the rate of unemployment has risen only marginally from 3.5 per cent to a still-far-below-average 3.9 per cent in November?

And if the economy’s been slowing for the whole of this year, how come the budget balance is getting better rather than worse, with Treasurer Jim Chalmers achieving a surplus last financial year and hoping for another in the year to next June?

There are lots of particular things that help explain these surprising results – world commodity prices have stayed high; some parts of the economy change earlier than others – but there’s one, more fundamental factor that towers over all the others: this is the first time in 50 years that we’ve been trying to slow a runaway economy that’s reached anything like full employment.

It turns out that throttling an economy that’s fully employed is much harder to do. Households are more resilient and, after a period when it’s been hard to get hold of all the workers they need, businesses have been far less inclined to add to the slowdown by shedding staff.

Remember that we reached full employment by happy accident. Between the unco-ordinated stimulus of state as well as federal governments, plus the Reserve cutting rates to near-zero, we (like many other rich economies) hit the accelerator far too hard during the pandemic.

This was apparent after the pandemic had eased and before the Morrison government’s final budget in March last year. But there was no way Scott Morrison was going to hit the budget brakes just before an election.

So the econocrats in the Reserve and Treasury resigned themselves to second prize: an unemployment rate much lower than what they were used to and felt comfortable with.

Because the pandemic had also caused us to close our borders and thus block employers’ access to skilled and unskilled immigrant labour, the econocrats got far more than they expected: unemployment so low we hit full employment.

The jobs market is getting less tight, with the number of job vacancies having fallen a long way, but last week’s figures for November showed how strong the labour market remains.

Sure, unemployment rose a fraction to 3.9 per cent, but this is no higher than it was in May last year. And the month saw total employment actually grow, by more than a remarkable 61,000 jobs during the month.

After all this slowing and all this pain, the rate at which people of working age are participating in the labour force by either having a job or actively seeking one has reached a record high.

And almost 65 per cent of the working-age population has a job – a proportion that’s never been higher in Australia’s history.

Employment is still growing strongly, partly because of the rebound in immigration, with foreign students in particular filling part-time job vacancies.

But also, it seems, because more hard-pressed families are trying to make ends meet by taking second jobs. In past downturns, those jobs wouldn’t have been there to be taken.

To force households to spend less, they’re being hit with three sticks. Obviously, by raising mortgage interest rates. Also by employers, taken as a group, raising the wages they pay by less than they’ve raised their prices (have you noticed how Chalmers avoids referring to the cut in real wages by just blaming “inflation”?).

And, third, by the government allowing bracket creep to take a bigger bite out of what pay rises the workers do manage to get.

But there’s another factor that’s been working in the opposite direction, adding to households’ ability to keep spending: over the year to November, the number of people with jobs rose by more than 440,000. That’s a full-employment economy.

All the extra people with jobs pay income tax. All the part-time workers able to get more hours pay more tax. All the people getting second jobs pay more tax. Add the bigger bite out of pay rises, and you see why Chalmers’ budget’s so flush.

But note this: the many benefits of full employment come at a cost – “opportunity cost”. As a coming paper by Matt Saunders and Dr Richard Denniss of the Australia Institute will remind us, “opportunity cost makes it clear that when resources are used for one purpose, they become unavailable for other purposes”.

So when we’re at or close to full employment, any developer, business executive or politician seeking our support for any project because “it will create jobs” should be laughed at. Where will the workers come from to fill the jobs? You’ll have to pinch them from some other employer.

This is especially true when the jobs you want to create are for workers with specialist skills.

According to a federal government report, in October last year there were 83 major resource and energy projects at the committed stage, worth $83 billion. But about two thirds of these were for the development of fossil fuels, including the expansion of nearby ports.

Really? And this at a time when the electricity grid needs urgent reconfiguration as part of our move to a low-carbon economy, but projects are being deferred because you can’t get the workers?

As Saunders and Denniss conclude, “With rapid population growth and the stated need to transform our energy system, the real cost of spending tens of billions of dollars building new gas and coal projects is the lost opportunity to invest in the infrastructure and energy transformation the Australian economy needs.”

I think Jim Chalmers needs to explain the iron law of opportunity cost to his boss. And make sure Climate Change and Energy Minister Chris Bowen’s in the meeting.

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Chalmers finds a better way to get inflation down: fix the budget

There’s an important point to learn from this week’s mid-(financial)-year’s budget update: in the economy, as in life, there’s more than one way to skin a cat.

The big news is that, after turning last year’s previously expected budget deficit into a surplus of $22 billion – our first surplus in 15 years – Treasurer Jim Chalmers is now expecting this financial year’s budget deficit to be $1.1 billion, not the $13.9 billion he was expecting at budget time seven months’ ago.

Now, though $1.1 billion is an unimaginably huge sum to you and me, in an economy of our size it’s a drop in the ocean. Compared with gross domestic product – the nominal value of all the goods and services we expect to produce in 2023-24 – it rounds to 0.0 per cent.

So, for practical purposes, it would be a balanced budget. And as Chalmers says, it’s “within striking distance” of another budget surplus.

This means that, compared with the prospects for the budget we were told about before the federal election in May last year, Chalmers and Finance Minister Katy Gallagher have made huge strides in reducing the government’s “debt and deficit”. Yay!

But here’s the point. We live in the age of “central bankism”, where we’ve convinced ourselves that pretty much the only way to steer the economy between the Scylla of high inflation and the Charybdis of high unemployment is to whack interest rates up or down, AKA monetary policy.

It ain’t true. Which means Chalmers may be right to avoid including in the budget update any further measures to relieve cost-of-living pressures and, rather, give top priority to improving the budget balance, thereby increasing the downward pressure on inflation.

The fact is, we’ve always had two tools or instruments the managers of the economy can use to smooth its path through the ups and downs of the business cycle, avoiding both high unemployment and high inflation. One is monetary policy – the manipulation of interest rates – but the other is fiscal policy, the manipulation of government spending and taxation via the budget.

This year we’ve been reminded how unsatisfactory interest rates are as a way of trying to slow inflation. Monetary policy puts people with big mortgages through the wringer, but lets the rest of us off lightly. This is both unfair and inefficient.

Which is why we should make much more use of the budget to fight inflation. That’s what Chalmers is doing. The more we use the budget, the less the Reserve Bank needs to raise interest rates. This spreads the pain more evenly – to the two-thirds of households that don’t have mortgages – which should be both fairer and more effective.

Starting at the beginning, in a market economy prices are set by the interaction of supply and demand: how much producers and distributors want to be paid to sell you their goods and services, versus how much consumers are willing and able to pay for them.

The rapid rise in consumer prices we saw last year came partly from disruptions to supply caused by the pandemic and the Ukraine war. There’s nothing higher interest rates can do to fix supply problems and, in any case, they’re gradually going away.

But another cause of the jump in prices was strong demand for goods and services, arising from all the stimulus the federal and state governments applied during the pandemic, not to mention the Reserve’s near-zero interest rates.

Since few people were out of job for long, this excessive stimulus left many workers and small business people with lots to spend. And when demand exceeded supply, businesses did what came naturally and raised their prices.

How do you counter demand-driven inflation? By making it much harder for people to keep spending so strongly. Greatly increasing how much people have to pay on their mortgages each month leaves them with much less to spend on other things.

Then, as demand for their products falls back, businesses stop increasing their prices and may even start offering discounts.

But governments can achieve the same squeeze on households by stopping their budgets putting more money into the economy than they’re taking out in taxes. When they run budget surpluses by taking more tax out of the economy than they put back in government spending, they squeeze households even tighter.

So that’s the logic Chalmers is following in eliminating the budget deficit and aiming for surpluses to keep downward pressure on prices. This has the secondary benefit of getting the government’s finances back in shape.

But how has the budget balance improved so much while Chalmers has been in charge? Not so much by anything he’s done as by what he hasn’t.

The government’s tax collections have grown much more strongly than anyone expected. Chalmers and his boss, Anthony Albanese, have resisted the temptation to spend much of this extra moolah.

The prices of our commodity exports have stayed high, causing mining companies to pay more tax. And the economy has grown more strongly than expected, allowing other businesses to raise their prices, increase their profits and pay more tax.

More people have got jobs and paid tax on their wages, while higher consumer prices have meant bigger wage rises for existing workers, pushing them into higher tax brackets.

This is the budget’s “automatic stabilisers” responding to strong growth in the economy by increasing tax collections and improving the budget balance, which acts as a brake on strong demand for goods and services.

There’s just one problem. Chalmers has joined the anti-inflation drive very late in the piece. The Reserve has already raised interest rates a long way, with much of the dampening effect still to flow through and weaken demand to the point where inflation pressure falls back to the 2 per cent to 3 per cent target.

We just have to hope that, between Reserve governor Michele Bullock’s monetary tightening and Chalmers’ fiscal tightening, they haven’t hit the economy much harder than they needed to.

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How Philip Lowe was caught on the cusp of history

Outgoing Reserve Bank boss Dr Philip Lowe was our most academically outstanding governor, with the highest ethical standards. And he was a nice person. But if you judge him by his record in keeping inflation within the Reserve’s 2 to 3 per cent target – as some do, but I don’t – he achieved it in just nine of the 84 months he was in charge.

Even so, my guess is that history will be kinder to him than his present critics. I’ve been around long enough to know that, every so often – say, every 30 or 40 years – the economy changes in ways that undermine the economics profession’s conventional wisdom about how the economy works and how it should be managed.

This is what happened in the second half of the 1970s – right at the time I became a journalist – when the advent of “stagflation” caused macroeconomists to switch from a Keynesian preoccupation with full employment and fiscal policy (the budget) to a monetarist preoccupation with inflation and monetary policy (at first, the supply of money; then interest rates).

My point here is that it took economists about a decade of furious debate to complete the shift from the old, failing wisdom to the new, more promising wisdom. I think the ground has shifted again under the economists’ feet, that the macroeconomic fashion is going to swing from monetary policy back to fiscal policy but, as yet, only a few economists have noticed the writing on the wall.

As is his role, Lowe has spent the past 15 months defending the established way of responding to an inflation surge against the criticism of upstarts (including me) refusing to accept the conventional view that TINA prevails – “there is no alternative” way to control inflation than to cut real wages and jack up interest rates.

If I’m right, and economists are in the very early stages of accepting that changes in the structure of the economy have rendered the almost exclusive use of monetary policy for inflation control no longer fit for purpose, then history will look back more sympathetically on Lowe as a man caught by the changing tide, a victim of the economics profession’s then failure to see what everyone these days accepts as obvious.

Final speeches are often occasions when departing leaders feel able to speak more frankly now that they’re free of the responsibilities of office. And Lowe’s “Some Closing Remarks” speech on Thursday made it clear he’d been giving much thought to monetary policy’s continuing fitness for purpose.

His way of putting it in the speech was to say that one of the “fixed points” in his thinking that he had always returned to was that “we are likely to get better outcomes if monetary policy and fiscal policy are well aligned”. Let me give you his elaboration in full.

“My view has long been that if we were designing optimal policy arrangements from scratch, monetary and fiscal policy would both have a role in managing the economic cycle and inflation, and that there would be close coordination,” Lowe said.

“The current global consensus is that monetary policy is the main cyclical policy instrument and should be assigned the job of managing inflation. This is partly because monetary policy is more nimble [it can be changed more quickly and easily than fiscal policy] and is not influenced by political considerations.”

“Raising interest rates and tightening policy can make you very unpopular, as I know all too well. This means that it is easier for an independent central bank to do this than it is for politicians,” he said.

“This assignment of responsibility makes sense and has worked reasonably well. But it doesn’t mean we shouldn’t aspire to something better. Monetary policy is a powerful instrument, but it has its limitations and its effects are felt unevenly across the community.”

“In principle, fiscal policy could provide a stronger helping hand, although this would require some rethinking of the existing policy structure. In particular, it would require making some fiscal instruments more nimble, strengthening the (semi) automatic stabilisers and giving an independent body limited control over some fiscal instruments.”

“Moving in this direction is not straightforward, but some innovative thinking could help us get to a better place,” Lowe said.

“During my term, there have been times where monetary and fiscal policy worked very closely together and, at other times, it would be an exaggeration to say this was the case.”

“The coordination was most effective during the pandemic. During that period, fiscal policy was nimble and the political constraints on its use for stabilisation purposes faded away. And we saw just how powerful it can be when the government and the Reserve Bank work very closely together.”

“There are some broader lessons here and I was disappointed that the recent Reserve Bank Review did not explore them in more depth,” Lowe said.

So was I, especially when two of Australia’s most eminent economists – professors Ross Garnaut and David Vines – made a detailed proposal to the review along the lines Lowe now envisages. (If Vines’ name is unfamiliar, it’s because most of his career was spent at Oxbridge, as the Poms say.)

But no, that would have been far too radical. Much safer to stick to pointing out all the respects in which the Reserve’s way of doing things differed from the practice in other countries – and was therefore wrong.

In question time, Lowe noted that one of the world’s leading macroeconomists, Olivier Blanchard, a former chief economist at the International Monetary Fund (and former teacher of Lowe’s at the Massachusetts Institute of Technology), had proposed that management of the economy be improved by creating new fiscal instruments which would be adjusted semi-automatically, or by a new independent body, within a certain range.

Lowe also acknowledged the way the marked decline over several decades in world real long-term interest rates – the causes of which economists are still debating – had made monetary policy less useful by bringing world nominal interest rates down close to the “zero lower bound”.

How do you cut interest rates to stimulate growth when they’re already close to zero? Short answer: you switch to fiscal policy.

But what other central banks – and, during the pandemic, even our Reserve Bank – have done was resort to unconventional measures, such as reducing longer-term official interest rates by buying up billions of dollars’ worth of second-hand government bonds.

Lowe said he didn’t think this resort to “quantitative easing” was particularly effective, and he’s right. I doubt if history will be kind to QE.

However, there’s one likely respect in which the ground has shifted under the economists’ feet that Lowe – and various academic defenders of the conventional wisdom – has yet to accept: the changed drivers of inflation. It’s not excessive wages any more, it’s excessive profits.

More about all this another day.

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