Alas Alan Kohler’s dalliance with reason appears over today as he calls for the RBA to hold no matter what:
The first thing Philip Lowe will have to do as incoming Reserve Bank Governor is to review, and re-express, the bank’s inflation target.
…Getting inflation up is rather more difficult. It has led to some remarkable and, according to many, absurd outcomes, such as the creation of money from thin air to buy bonds from banks, negative official interest rates in many countries and, this year, even talk of “helicopter money” — or simply depositing into people’s bank accounts money conjured by the central bank.
…In my view, the property market has not been a bubble up to now, but it could easily turn into one with another 0.5 per cent off interest rates. That’s especially so if growth stays at 3 to 4 per cent and unemployment at 5.5 per cent, as Treasury predicts.
…Lowe needs to lead a re-examination of the inflation target by the RBA, and, at the very least, he should explicitly emphasise the flexibility of the 2-3 per cent target and suggest the bank will not necessarily chase it.
You may get your wish, Alan. Phil Lowe criticised the Macfarlane RBA for cutting rates too far during Australia’s late 1990s productivity boom:
This more flexible approach has two advantages. The first is that, in the event that inflation turns out to be unexpectedly too high or too low, the central bank has some flexibility about the pace at which inflation is returned to the target range. Provided the central bank’s commitment to medium-term price stability is credible, this flexibility can deliver better outcomes for the real economy.
The second advantage is that this flexibility provides greater scope to take into account not just the central forecast, but also the medium-term risks around that forecast.
Let me try and make this a little more concrete by asking you to think about an economy that experiences a positive supply shock, say an improvement in productivity or lower world prices for the goods that it imports. Normally, this type of shock would be expected to boost economic growth, increase asset returns and lower inflation, at least for a time.
What then is the right monetary policy in this economy? In a world in which the setting of policy is determined solely by the two-year-ahead inflation forecast, the answer may well be to lower interest rates. If inflation is forecast to be below the target midpoint in two years time, lower interest rates, at least for a while, would help get inflation closer to target.
But would lower interest rates be the best response? To answer this I would need to tell you some more parts of the story. If asset prices were rising very quickly, investors were exuberant, and the financial sector was making credit liberally available, then lowering interest rates simply to hit the inflation target at one specific point in the future may not be the best response. Experience has taught us that low interest rates at a time of rapid increases in leverage and asset prices can pose significant medium-term risks to the outlook for the economy and for inflation. Ignoring these risks, and making leverage cheaper by lowering interest rates, simply to ensure that the short-term inflation forecast was at the target, is unlikely to be the best policy.
The general point here is that while the central forecast for inflation itself will often provide a good guide for policy, this will not always be the case. On some occasions, the medium-term risks are just as important.
Yes, they are. But those medium term risks for Australia are not just an even bigger housing bubble (yes, Alan, there is one already), they are the steady failure of the post mining boom adjustment as the Aussie dollar refuses to fall fast enough. This poses a quandry for the RBA as we know, one that was long ago described by Henry Thornton:
This article aims to convince the board of the Reserve Bank and the government to introduce a variable tax on capital inflow to enable the Reserve to continue to control inflation without an exchange rate that is severely handicapping many Australian industries. If this is not done, either inflation will be ignited here by further cuts of interest rates or great sections of industry will be wiped out by a high dollar that with a high cost base makes businesses globally uncompetitive.
This matter is urgent as the RBA’s current approach – which is seeking a safe path between two conflicting objectives – has already damaged Australia’s industrial base and further damage will be far greater if the advice offered here is not followed.
There is a vital historical precedent for the problem now facing the RBA. The US Federal Reserve in the 1920s faced a booming economy and rising share prices. US monetary policy could not both restrain the boom and prevent what became a massive share price bubble whose eventual bursting was an important reason for the onset and severity of the economic downturn we all call the Great Depression. Milton Friedman and Anna J. Schwartz say in their monumental bookA Monetary History of the United States 1867 to 1960: ‘… there is no doubt that the desire to curb the stock market boom was a major if not dominating factor in Reserve actions during 1928 and 1929. … But they did exert steady deflationary pressure on the economy. … that episode … exemplifies the difficulties raised by seeking to make monetary policy serve two masters’. (pp 290 – 291).
As it turned out the problem is not inflation but deflation as the monumental income shock of the terms of trade bust (which is only half over) has its way. But the problem remains the same. The RBA can only choose (asset) price stability or a lower currency, not both.
At least in theory. As it happens, I don’t think that the bubble will get much bigger given the investor mania has burst, the Chinese bid is collapsing, the banks will hold back roughly half of further cuts, and the real interest rate is rising anyway. My own view is that housing is in for a longish stall top followed by an interminable fall even as rates plunge to our version of zero (05-0.75%).
But that does not excuse Mr Kohler’s half-baked reasoning. If he is concerned by the bubble, suddenly, then he has two sensible arguments to make:
- vote Labor so that negative gearing is reformed enabling the RBA to focus on price stability, or,
- encourage the RBA to extend its macroprudential regime.
His current proposed solution of the RBA holding rates no matter what is still a recipe for disaster.
