Low inflation may mean higher rates

Alan Wood | October 29, 2009

Article from:  The Australian

THERE is no mystery about what the Reserve Bank of Australia is up to. With the local economy clearly recovering, our central bank has decided it is time to start moving official interest rates back to a more normal level.

It began to do so at its board meeting earlier this month, when it raised the official cash rate by 25 basis points, and its economic forecasts embody further rate rises during the next year.

RBA governor Glenn Stevens is reluctant to say exactly what a normal (also called neutral) level may be, although his predecessor Ian Macfarlane once suggested a nominal cash rate of 5 per cent to 6 per cent.

Whether this is still an appropriate level is not an immediate issue because, as Stevens said a couple of weeks ago, the official cash rate is clearly still some distance below whatever the neutral rate may be, even after this month's rate rise.

The immediate issue is how fast rates should rise, and Stevens acknowledged that the higher level of leveraged debt in some areas of the economy (notably households) was a reason to be careful.

Another possible reason for caution is that Australia's interest rates are already higher than those in other advanced economies, with rates in the US, Britain, Japan and Canada at close to zero. The interest rate gap is a factor in the high Australian dollar exchange rate, which helps keep downward pressure on inflation but squeezes exporting and import-competing industries.

Although it will have some influence, the exchange rate is not likely to be a significant factor holding back the RBA's rate rise decisions. If the Australian dollar remains strong or gets stronger, an important reason will be because markets are adjusting to the prospective effects of a commodity boom on Australia, and that carries with it risks of future strong inflationary pressures.

The latter raises medium-term issues for monetary policy.

The minutes of the RBA's October board meeting told us that while inflation was expected to fall in the coming year, the expected trough in inflation was now significantly higher than it earlier thought. The minutes went on to warn this meant keeping rates at very low levels could threaten the achievement of the bank's 2 per cent to 3 per cent inflation target during the medium term.

Yesterday's inflation numbers, which had the quarterly rate of underlying inflation at 0.8 per cent, would have done nothing to alleviate this concern. However, they also give no reason for the 50 basis point rise in November that some in the market have been suggesting.

But there is tension between the RBA's short-term caution and its concerns about the inflation outlook in 18 months or so, which suggest moving back to a neutral level more quickly than purely short-term considerations would dictate.

A reasonable guess is that by next March official cash rates will be at 4per cent, which is only three 25 basis point rate rises away and hardly a radical move from the 3per cent emergency setting.

If the RBA's view of economic prospects, with a return to trend growth here next year and a medium-term outlook dominated by strong terms of trade from a China-led resource boom, is right, they of course won't stop there.

How far they rise will depend on the extent of pressures on the RBA's 2per cent to 3 per cent inflation target, about which the bank is already worrying.

A rise in rates above neutral - whether neutral is 5 per cent or 6 per cent, or some other number - seems likely when we look beyond next year.

This raises important medium-term questions for monetary policy.

Will pressure be exerted on the central bank to relax its 2 per cent to 3per cent inflation target in response to the price and more general economic adjustment forces generated by historically high terms of trade? You bet it will. And what will its response be? Recent history suggests an unpopular one.

Pressures for it to accept a higher trend inflation target were clearly emerging before the global financial crisis, a popular argument for doing so being that the rise in prices came from external factors beyond our control. It was an argument Stevens strongly attacked in a 2008 speech, from which this is a highly relevant extract:

"We can all see that the main external event of recent years is the rise in the terms of trade, which is obviously completely exogenous as far as Australia is concerned. Though monetary policy cannot stop the initial shock - of course we cannot stop the Chinese demand for resources - we can and should seek to condition the economy's subsequent response to that shock, rather than simply letting domestic overheating go unchecked.

"Tighter (monetary) policy will dampen domestic demand and contain the pick-up in non-traded prices as well as raising the exchange rate, which makes imports cheaper, exports less competitive and fosters a move of productive resources into the parts of the economy where more production is needed.

"That is an appropriate form of adjustment to such a shock, particularly if the shock is likely to be fairly persistent."

Don't say you haven't been warned if rates end up at painfully high levels as the RBA defends its inflation target. The alternative is worse. For the RBA to soften its inflation target would, through time, lead to rising inflation expectations and even higher interest rates in this economy. The RBA's inflation target has credibility, and with credibility go lower average interest rates.

What happens when expectations about how monetary authorities will respond to economic shocks are shattered was dramatically on display in last year's collapse of Lehman Brothers. Financial markets expected the US Federal Reserve and Treasury would rescue such a systemically important financial institution. When they didn't, global financial markets panicked and the world's financial system went to the brink of meltdown, dragging the world economy down with it and leading to large-scale government interventions.

It is unlikely to be a lesson lost on central bankers with inflation targets, including Australia's.

But so far all that is happening here is that monetary policy is being moved to a less expansionary stance from a very expansionary one.

As Treasurer Wayne Swan said when Stevens raised rates this month, nobody could expect rates to remain at 50-year lows forever. Many, of course, would like them to.

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