When interest rates seem likely to be raised more than they need to be, it’s only human to blame the bloke with his hand on the lever, Reserve Bank governor Dr Philip Lowe. But it’s delusional to imagine that fixing the problem with “monetary policy” is simply a matter of finding a better person to run it.
This assumes there’s nothing wrong with the policy of using the manipulation of mortgage interest rates as your main way of managing the economy and keeping inflation low and employment high. In truth, there’s a lot wrong with it.
It ought to be a happy coincidence that, just as our central bank is making heavy weather of its first big inflation problem in decades, the Albanese government had already commissioned a review of its performance.
Treasurer Jim Chalmers will receive its report late next month. But particularly because the review is headed by an overseas central banker, it’s likely to recommend relatively minor changes to the way the Reserve performs its present role – changing the composition of its board, for instance – rather than answer a more fundamental question: can’t we find a better way to manage the macroeconomy than relying so heavily on dicking around with interest rates?
It’s a pity you have to be as ancient me to know there’s nothing God-ordained about the notion that central banks must have primary responsibility for stabilising the economy, with the elected government’s “fiscal policy” (the manipulation of government spending and taxes) playing a subsidiary role, and the central bankers being independent of the elected government.
This arrangement became the conventional wisdom only in the mid-1980s, after many decades of relying mainly on using the budget, with monetary policy’s job being to keep interest rates permanently low.
The fact is that, as instruments for managing demand, monetary policy and fiscal policy have differing strengths and weaknesses. The switch from fiscal to monetary primacy seemed to make sense at the time, and to hold the promise of much more effective stabilisation of the economy as it moved through the ups and downs of the business cycle.
Then, we were very aware of the limitations of fiscal policy. But after 40 years, the limitations of monetary policy have become apparent. For one thing, we learnt from the weak growth in the decade following the global financial crisis that monetary policy is not effective in stimulating growth when interest rates are already very low and households already loaded with debt.
Now we have high inflation caused primarily by problems on the supply (production) side of the economy. Can monetary policy do anything to fix supply problems? No. All it can do is keep raising interest rates until the demand for goods and services falls back to fit with inadequate supply.
But as a tool for limiting demand, monetary policy turns out to be primitive, blunt and unfair. Its manipulation of interest rates has little effect on borrowing for business investment, and little direct effect on all consumer spending except spending on mortgaged or rented housing.
In practice, this means monetary policy relies on manipulating the housing market to influence consumer spending indirectly. When you want to encourage demand, you cut mortgage interest rates to rev up the housing market. When you want to discourage demand, you raise rates to smash the housing market.
Putting up mortgage interest rates discourages people from buying housing – including newly built homes, which hits the home-building industry directly. But by increasing mortgage payments and rents, it hits consumer spending indirectly, by leaving households with less to spend on other things.
See how round-about monetary policy is in achieving its objective? It hits some people hard, but others not at all. As a reader wrote to me: “It just doesn’t make sense to me that one segment of the population is going through financial pain and suffering when others aren’t affected. Surely, there are [other] ways the government or Reserve Bank can bring inflation under control?”
Good point. Why does stabilising the economy have to be done in such a round-about and inequitable manner? As other readers would tell me, why do older people dependent on interest income have to take a hit whenever the Reserve decides to encourage borrowing and spending by cutting interest rates?
Truth is, central banks can’t afford to worry about whether dicking around with interest rates is fair or unfair: it’s the only tool they’ve got. To someone with a hammer, every problem is a nail.
And although economists have forgotten it, there are other, less round-about and less unfair ways to discourage or encourage consumer spending. In the olden days, governments added a temporary surcharge or discount to the income tax scale.
These days, you could do the same to the rate of the goods and services tax. If you didn’t trust the pollies to do it, you could give the power to an independent commission.
The Reserve rightly asserts that many of the price rises we’ve seen can’t be explained by supply problems, but must be attributed to excessive demand, caused by all the stimulus unleashed during the pandemic.
It fits the monetary policy-primacy mindset to blame this on excessive fiscal stimulus via all the temporary government spending and tax breaks. But a much better case can be made that the excess came from monetary policy.
Indeed, the response to the pandemic may have been far less inflationary than it proved to be had the Reserve left it all to fiscal policy. Since, with the official interest rate already down to 0.75 per cent, it was already almost out of ammunition, I expected the Reserve to sit it out and leave the heavy lifting to fiscal policy.
But no, like the other rich-country central banks, the Reserve leapt in. And, not content with cutting the official rate to 0.1 per cent, it resorted to various unconventional measures, lending to the banks at discount rates and buying several hundred billions-worth of government bonds to lower also multi-year housing fixed interest rates.
While the Reserve was doing this, both federal and state governments were offering people special concessions to buy newly built homes. The combined effect was to give the housing industry a humungous boost. House prices soared, as did the cost of a new home once the supply of building materials and labour ran out.
Guess what? If you take the part of our rise in consumer prices that can’t be attributed to supply problems and imported inflation, you find much of it’s explained by the cost of building a new home, which rose by an amazing 27 per cent over the 18 months to December.
It’s reasonable to believe that our inflation wouldn’t be nearly as bad, had the Reserve left the coronacession to fiscal policy, as it should have. Why didn’t it? Because it, like the other rich-country central banks, now thinks it owns macroeconomic management.
It just had to be out there, pushing the treasurer and Treasury away from the microphone and showing it was in charge – while it made matters worse. This is the central banking problem we - and the other rich countries - should be grappling with.