I was in a meeting the other day and was asked a question on what the implications of the higher savings rate (and consequent fall in demand for credit and lower retail sales) would be on interest rates and would the RBA have to act to address this issue. The answer I gave was off the cuff but it surprised me in-so-far as I had not actually had a conscious thought which tied up with the answer.
I said that I thought the RBA had undergone a change in their structural bias when it’s comes to interest rates. That is, in the world of falling inflation and a goal of full employment they had had a structural bias to ease but that now, with inflation on the rise again, nominal full employment and a mining boom, they have a structural bias to tighten.
This comment has bedevilled me since last Tuesday as I grapple with the macro-economic implications of this for the Australian economy and the myriad different inputs into the RBA’s monetary decision process when setting monetary policy on the first Tuesday of each month.
To illustrate my point, I have dug up the RBA speech’s and paper that are relevant for this discussion and while I’m not claiming to have an exhaustive list I think I have my answer.
The thing that strikes me as different about the RBA from other central banks around the world is their lack of dogma in favour of the practical application of monetary policy and the candour with which they speak in public. That is not to say they simply float with the tide of whatever trend is in markets or economics but it strikes me that they follow a “do least harm” (to the economy) doctrine in the application of their charter and duties.
So how do these methods lead me to conclude that the RBA has a structural bias to tighten these days?
To wit, speaking in July 2006 at the Anika Foundation RBA Governor Glenn Stevens (when he was Deputy to Ian Macfarlane) gave a speech on the “Conduct of Monetary Policy” where he set out an “exposition of the decision process and principles that have guided our actions”. You might argue that this is a little historic in that almost 5 years have passed but having watched the RBA up close and personal since 1988 I would say it is representative of their approach since the mid 1990’s.
Steven’s articulated the fact that the community understands that the RBA’s goal is to keep inflation under control and that:
…the way to keep inflation and interest rates low on average is to be prepared to put rates up modestly, but promptly, when inflation pressures start to increase.
He posed the rhetorical question as to what information is relevant for the monetary policy decisions and his answer was essentially everything.
…there is no single variable which is the key, and the best guide to our behaviour is going to be to look at the whole picture, to remember what policy is aiming to do – that is, to keep average inflation at 2-3 per cent, ameliorating where possible fluctuations in the real economy – and go from there.
The second question in deciding whether or not to change rates is the “standard of proof”. Stevens answer on this was that it should neither be a hair trigger, moving with the flow of the latest piece of data as this presents unnecessary volatility as rates would have to be moved one way and the other. But neither should it be “murder trial’ standard because it would impart too much inertia.
And here is the key for our current situation. In asking how the right balance might be struck Stevens said that policy makers should be:
…wary of strong conclusions drawn from short runs of data. Policy has to be more cognisant of the longer-run, usually more powerful, forces at work and not be distracted by ephemeral developments. And, of course, it is well understood that policy has to be forward looking. That means it has to use forecasts. After all, if monetary policy takes some time – several years – to have its full effect on the economy and inflation, forecasts have to be at the centre of things, don’t they?
For those of you who are interested in a better understanding of the process of monetary policy setting this speech is worth a read. For the purposes of this argument, I can summarise the rest to mean that Stevens advocates a position where the RBA holds a “central forecast” of the medium term economy and then looks at the range of “plausible outcomes” around this forecasts and the risk associated with them.
It is the central forecast and the plausible risks around that forecast that are relevant to us all now.
This point is born out by a look at what RBA Assistant Governor Phillip Lowe said in a speech back in September 2006 titled “Risk Measurement – A Central Bank Perspective”. Dr Lowe was specifically interested in the question of how you measure risk in a world of structural change. Granted the structural change that principally concerned him (and it must be said Stevens in the speech above) was the transformation of the household balance sheet (not for the better in anybody’s hindsight), a change that I believe is and will continue to be unwound. But the key for 2011 and beyond is that like Stevens before him Lowe highlighted the need for scenario analysis in a world that is undergoing structural change.
Which is where we find ourselves again today. With the world undergoing an accelerated structural change toward developing economy-led growth and Australia enjoying an evolution toward the commodity investment that feeds it.
On September 17th 2008 Glenn Stevens gave a speech to the AICD titled “The Directors’ Cut: Four Important Long-run Themes”. You won’t be surprised to see what those themes were and my guess still are:
The themes are: the emergence of China; the economics of a fully employed economy; the end – perhaps? – of the long period of households leveraging up their finances; shifting perspectives about the regulation of the financial sector in the economy.
Stevens went on to say that:
China’s emergence is surely far from complete. China, like all economies, will have cycles. But its average growth rate is likely to be pretty high for years ahead, even if not as high as it has been recently.
Which is pretty much what he said in New York last week. Time has likely reinforced the RBA’s view on the China boom as various speeches and Bulletin articles over the past 3 years highlight. The core theme that always comes out is that China and India are on a multi-decade growth path which will underpin demand for Australian commodities for decades. It also underpins investment and the structural change that is driving up mining’s share of the economy. The RBA believes in this boom and the transformative impact on the economy.
So, we have an RBA that focuses very much on a medium term central forecast and the current one is for ongoing commodity strength. Returning to our opening question then, how will consumer spending effect this? In 2008, Stevens said of household balance sheets:
…there is also a good chance that households will for some time seek to contain and consolidate their debt, grow their consumption spending at a pace closer to income, and perhaps look to save more of their current income than in the recent past. It is possible that we are witnessing the early part of a new phase where the household spending and borrowing dynamic is different from the past decade and a half.
Time will tell. But if that is the trend of the next several years, the growth opportunities for businesses and financial institutions will be different. And whereas the household balance sheet has been the big financial story of the past 15 years, some other financial trend will probably be the bigger story of the next decade.
Clearly in 2008 the RBA was uncertain but doubtful of the durability of the new savings trend. It is still my sense when I see RBA Board Meeting Communiqués and minutes and hear speeches from RBA officials that our central bankers think this household caution is transitory. It’s as if they’re just waiting for the wall of mining and terms of trade money to flow through the economy and wash out the spending recalcitrance. I believe the shift to saving is structural and indeed an unwinding of the previous 15-20 years debt build up. But the RBA reckons spending will be back. Thus the finger remains on the trigger.
There is one more crucial point to make. Stevens also talked about the “Economics of Full Employment” in this speech and I think this is the key to my assertion that the RBA may have a structural bias to tighten for the next decade or so. Stevens said:
Let’s be clear that full employment is a good thing. It is one of the statutory objectives given to the Reserve Bank in our Charter (though interestingly the authors of the Act never quantified what they meant by full employment, nor for that matter, by ‘stability of the currency’).
But the economics of full employment are different from the economics of trying to get to full employment. This is a simple point, but an important one. When the economy has too much spare capacity – say, in the aftermath of a business cycle downturn – the aim of macroeconomic policies is to push up demand so that it catches up to supply potential.
Stevens added that if we are at full-employment then our growth rate must fall to match the growth rate of supply and in order for us to increase our (non-inflationary) growth rate we need to increase either our supply or productivity. Recently, the participation rate in labour markets has risen to an all-time high (increasing supply of labour) which has kept unemployment above the worryingly low level, which, for the RBA, is around 5%.
Just to ice the cake, in 2010, a paper written by Norman and Richards of the RBA’s Economic Analysis Department found that the Phillips Curve (the inverse relationship between unemployment and inflation) is alive and working well as a predictor of inflation in Australia. Indeed the authors found that this measure was far superior to monetary models of inflation or the influence of oil prices.
In summary, from the RBA’s standpoint, Australia has a central forecast of an ongoing mining boom at a time of almost full employment and they continue to believe that household restraint is transitory. If the Australian economy is going to be able to grow in a non-inflationary way then the RBA will need to continue to push down consumption to make way for the boom and tight employment markets. That is a structural tightening bias and it’s long term.