Saturday, June 20, 2015
Whether you look at the way the major developed countries' resort to massive "quantitative easing" (creating money) hasn't exactly got their economies booming, or at the way our big cuts in the official interest rate haven't seen us return even to average ("trend") growth, it makes you doubt if "monetary policy" - the manipulation of monetary conditions - still packs a punch.
Consider our story. The Reserve Bank began cutting the official interest rate as long ago as November 2011. By August 2013 it had reduced it by 2.25 percentage points to a historic low of 2.5 pc. This year it's made more cuts to 2 per cent.
And yet the economy continues growing below trend and isn't expected to return to healthy growth before 2016-17.
Enter Dr Christopher Kent, an assistant governor of the Reserve. In his speech this week he didn't deny the facts: interest rates have been very low for a long time without there being any noticeable pick-up in growth.
But he did dispute the conclusion that this meant monetary policy had lost its power to stimulate economic growth. His point is that when we look at the position in the way I've just done, we're implicitly assuming "ceteris paribus" - that all else remained equal while the only thing that changed was the level of the official interest rate.
Obviously, a lot of other things changed over the period. To take just the most obvious examples, the big fall in coal and iron ore prices, the movement in the dollar and the impact of "fiscal policy" - the effects of the federal and state budgets.
To try to take account of all the things that change, not just interest rates, you need to use a sophisticated econometric model of the economy. And when Kent's people at the Reserve do this, their estimates "tentatively suggest that the overall effect of monetary policy has not changed significantly in recent years".
Such models have two kinds of variables "exogenous" and "endogenous". Exogenous variables are set by the modeller, whereas endogenous variables are determined by the model and its assumptions about how the economy works.
Kent says that in modelling work using a "dynamic stochastic general equilibrium" model (don't ask), estimates of the endogenous relationships based on the figures up to 2008 (the time of the global financial crisis) are about the same as estimates based on figures since then.
"This suggests that the period of below-trend growth in gross domestic product over the past few years may not reflect a change in the monetary policy transmission mechanism," he says.
"Rather, the model attributes below-trend growth to sizeable exogenous forces or shocks. The sharp fall in commodity prices has played an important role of late. Also, weakness in private investment - beyond that which can be explained by subdued domestic demand and falling commodity prices - has made a sizeable contribution to below-trend growth."
I think here he's alluding to the adverse effect on business investment of the still-too-high dollar.
"The model also suggests that consumption growth has been a bit weaker than in the past," he says.
Measuring the effects of monetary policy in isolation from other changes that may be happening at the time, this modelling tells us that a cut in the official interest rate of 1 percentage point will lead the level of real GDP to be between about 0.5 per cent and 0.75 per cent higher than it otherwise would be in two years' time.
It will also lead the level of prices to rise by a bit less than 0.25 percentage points a year more than otherwise over the next two to three years.
Of course, one part of the economy that has strengthened in response to low interest rates is housing construction. It's up by about 9 per cent over the past year.
Kent says housing is typically the most interest-rate sensitive sector and its response to date is "broadly consistent with historical experience".
Consumer spending, however, has so far been "a bit weaker over recent years than suggested by historical experience".
But much of that history captures the unusual period, from the early 1990s to the mid-2000s, of adjustment to the easier access to housing credit permitted by the deregulation of the banks and to the economy's return to low inflation.
In that period, household debt increased substantially and household saving fell to rates much below earlier norms. This allow households' consumption spending to grow faster than their incomes.
Since then, however, households' behaviour has reverted to its earlier norms, with a higher rate of saving and greater emphasis on repaying mortgages as early as possible.
If you ignore the growth in borrowing for investment property, but take account of the rising balances in mortgage offset accounts, the rest of household debt has fallen by 4 percentage points of annual household disposable income since early 2000.
Kent thinks many households are using the lower rates to repay their mortgages more quickly (rather than to borrow and spend more) and that some retired households are responding to their lower interest income by limiting their consumption.
As for non-mining business investment, businesses will start expanding their activities when they're closer to running out of spare production capacity. Business investment doesn't usually lead, it follows.
Kent concludes that monetary policy is working pretty much the way it always has, but is pushing against "some strong headwinds", including the huge fall-off in mining investment, tightening budgets at state and federal level and an exchange rate that's still higher than you'd expect it to be considering how far export prices have fallen.