Showing posts with label interest rates. Show all posts
Showing posts with label interest rates. Show all posts

Monday, July 24, 2023

Beating inflation shouldn't just be left to higher interest rates

Everyone’s heard the surprising news that last financial year’s budget is now expected to run a surplus of about $20 billion, but few have realised the wider implications. They strengthen the case for relying less on interest rates to fight inflation.

But first, the news is a reminder of just how bad economists are at forecasting what will happen to the economy – even in not much more than a year’s time. Which shows that economists don’t know nearly as much about how the economy works as they like to imagine – and like us to believe.

Then-treasurer Josh Frydenberg’s budget in March last year forecast a budget deficit in 2022-23 of $78 billion. By Jim Chalmers’ second go at the budget last October, that became a deficit of about $37 billion.

By the following budget, in May, the best guess had turned into a surplus of $4 billion. And just two months later – and that financial year actually over – the best guess is now a surplus of about $20 billion.

That’s a forecasting turnaround, over the course of only about 15 months, of almost $100 billion, or 4 per cent of gross domestic product.

What did Treasury get so wrong? It grossly underestimated the growth in tax collections. This was partly because it assumed a fall in the prices of our key commodity exports that didn’t happen, thus causing the company tax paid by our miners to be higher than expected.

But mainly because collections of income tax were much higher than expected. The economy grew at close to full capacity, so more people found jobs and many part-time workers got more hours or became full-time.

A huge number of new jobs have been created, almost all of them full-time. Do you realise that a higher proportion of people aged over 15 have paid employment than ever before? The rate of unemployment fell to its lowest in 50 years and many people who’d been unable to find a job for many months finally succeeded.

Obviously, when people find work, they start paying income tax, and stop needing to be paid unemployment benefits. So full employment is excellent news for the budget.

But the rapid rise in the cost of living during the year caused workers to demand and receive higher pay rises, even though those rises generally fell well short of the rise in prices.

So all the people who already had jobs paid more tax, too. But not only that. Our “progressive” income tax scale – where successive slices of your income are taxed at progressively higher rates – means that pay rises are taxed at a higher rate than you paid on your existing income.

Ordinary mortals call this “bracket creep”. Economists call it “fiscal drag”. Either way, the higher rate of tax workers paid on their pay rises also made a bigger-than-expected contribution to income tax collections and the budget balance.

Note that this unexpected move from deficit to surplus in the financial year just past, this underestimation of the strength of tax collections, has implications not only for the size of the government’s debt at June 2023, it has implications for the size of tax collections in the next few years, as well as for the amount of interest we’ll have to pay on that debt this year and every year until it’s repaid (which it won’t be).

In Frydenberg’s budget in March last year, the projected cumulative deficit for the five financial years to June 2026 was just over $300 billion. By the budget in May, this had dropped to $115 billion.

And now that we know last year’s surplus will be about $20 billion, the revised total projected underlying addition to government debt should be well under $100 billion.

Get it? Compared with what we thought less than 16 months ago, the feds’ debt prospects aren’t nearly as bad as we feared. And the size of our “structural” deficit – the size of the deficit that remains after you’ve allowed for the ups and downs of the business cycle – isn’t nearly as big, either.

Which suggests it’s time we had another think about our decision in the late 1970s – along with all the other rich economies – to shift the primary responsibility for managing the macroeconomy from the budget (“fiscal policy”) to the central bank and its interest rates (“monetary policy”).

One of the arguments used by the advocates of this shift was that fiscal policy was no longer effective in stimulating the economy. But our remarkably strong growth since the end of the pandemic lockdowns shows how amazingly effective fiscal policy is.

It’s now clear that fiscal “multipliers” – the extent to which an extra $1 of deficit spending adds to the growth in real GDP – are much higher than we believed them to be.

We know that a big part of the recent leap in prices was caused by shocks to the supply (production) side of the economy arising from the pandemic and the Russia-Ukraine war. But central banks have argued that a second cause was excessive demand (spending), which happened because the stimulus applied to cushion the effect of lockdowns proved far more than needed.

If so, most of that stimulus came from fiscal policy. Our official interest rate was already down to 0.75 per cent before the pandemic began. So, further proof of how powerful fiscal stimulus still is.

But another implication of the $20 billion surplus is that the stimulus wasn’t as great – and its ultimate cost to the budget wasn’t as great – as we initially believed it would be.

In the budget of October 2020, the expected deficit of $214 billion in 2020-21 was overestimated by $80 billion. In the budget of May 2021, the expected deficit of $107 billion in 2021-22 was overestimated by $75 billion. And, as we’ve seen, the deficit for 2022-23 was initially overestimated almost $100 billion.

This says two things: the fiscal stimulus caused the economy to grow much faster than the forecasters expected, even though the ultimate degree of stimulus – and its cost to the budget – was much less than forecasters expect.

Economists know that the budget contains “automatic stabilisers” that limit the private sector’s fall when the economy turns down, but act as a drag on the private sector when the economy’s booming.

We’ve just been reminded that the budget’s stabilisers are working well and have been working to claw back much of the fiscal stimulus, thereby helping to restrain demand and reduce inflation pressure.

Whenever departing Reserve Bank governor Dr Philip Lowe has been reminded of the many drawbacks of using interest rates to manage the economy, his reply has always been: sorry, it’s the only instrument I’ve got.

True. But it’s not the only instrument the government has got. It should break the central bank’s monopoly on macro management and make more use of fiscal policy.

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Friday, May 19, 2023

Chalmers and Lowe: good cop, bad cop on the inflation beat

Have you noticed? There’s a contradiction at the heart of Treasurer Jim Chalmers’ budget. Is it helping or harming inflation?

Both Chalmers and Reserve Bank governor Dr Philip Lowe are agreed that our top priority must be to get the rate of inflation down. That’s fine. Everybody hates the way prices have been shooting up. The cost of living has become impossible. Do something!

But while Lowe seems to be just making it all worse, jacking up mortgage interest rates higher and higher, nice Mr Chalmers is using his budget to take a bit of the pressure off, helping with electricity bills, cutting prescription costs and so on.

It’s as though Lowe is the arsonist, sneaking round the bush to start more fires, while Chalmers is the Salvos, turning up at the scene to give the tired firefighters a kind word, a pie and a cup of tea.

Is that how you see it? That’s the way Chalmers wants you to see it, and Lowe knows full well it’s his job to be Mr Nasty at times like this.

But what on earth’s going on? Has the world gone crazy? No, it’s just the usual dance between brutal economics on one hand, and always-here-to-help politics on the other.

Let’s start from scratch. Why do we have an inflation problem? Because, for the past 18 months or so, the prices of the things we buy have been shooting up, rising much faster than our wages, causing the cost of living to become tough for many people.

Why have prices been rising so rapidly? Partly because the COVID-19 pandemic and Russia’s attack on Ukraine caused international shortages of building materials, cars, computer chips and fossil fuels. But also because the massive increase in our governments’ payments during the pandemic left us cashed up and spending big on locally made goods and services.

When the suppliers of the stuff we buy can’t keep up with our demand for it, they raise their prices. The media may call this “price gouging”, but economists believe it’s what happens naturally in a market economy – and should happen because the higher price gives the suppliers an incentive to produce more. When they do, the price will come down.

When inflation takes off like this, what can the managers of the economy do to stop prices rising so fast? They can do nothing to magically increase supply; that takes time. But what they can do is reduce demand – discourage us from spending so much.

How? This is where it gets nasty. By squeezing households’ finances so hard they have to cut their spending. Once demand for the stuff they’re selling falls back, businesses are much less keen to raise their prices.

At present, households are being squeezed from all directions. The main way is that wages aren’t keeping up with the rise in prices. As well, more of the wage rises people are getting is being eaten up by income tax, thanks to “bracket creep”.

And the fall in house prices means home-owning households aren’t feeling as wealthy as they were.

All that’s before you get to Mr Nasty, raising the interest rates paid by people with mortgages, which is particularly tough on young home owners, with more recent, much bigger mortgages.

(You may wonder if this extra pressure on, say, only about 20 per cent of all households is either fair or the most effective way to get total household spending to slow. And you may be right, but you’d be way ahead of the world’s economists, who think the way they’ve always done it is the only way they could do it.)

But what part is the budget – “fiscal policy” – supposed to play in all this? It should be helping put the squeeze on, not reducing it. Now do you see why some are questioning whether Chalmers’ $14.6 billion “cost-of-living relief package” will help or hinder the cause of lower inflation?

The budget balance shows whether government spending is putting more money into the economy, and its households, than it’s taking out in taxes. If so, the budget’s running a deficit. If it’s taking more money out than it’s put back in, the budget’s running a surplus.

The way the Reserve Bank judges whether the budget is increasing the squeeze on households, or easing it, is to look at the size and direction of the expected change in budget balance from one year to the next.

The budget papers show the budget balance is planned to change from an actual deficit of $32 billion last financial year, 2021-22, to an expected surplus of $4 billion in this financial year, ending next month.

That’s an expected tightening of $36 billion, equivalent to 1.6 per cent of the size of the whole economy, gross domestic product.

No doubt such a change is adding a big squeeze to household incomes. But then the budget balance is expected to worsen in the coming financial year, 2023-24, to a deficit of $14 billion. That’s an easing of pressure on households’ finances equivalent to 0.7 per cent of GDP.

Put the two years together, however, and its clear the budget will still be putting a lot of squeeze on households – on top of all the other squeeze coming from elsewhere.

Somewhere in there is most of Chalmers’ $14.6 billion relief package. As a matter of arithmetic, it’s undeniably true that, had the package – which, by the way, is expected to reduce the consumer price index by 0.75 percentage points – not happened, the squeeze would be, say, $10 billion tighter than it’s now expected to be.

But there’s no way, looking at that – and all the other sources of squeeze – the Reserve will be saying, gosh, Chalmers is adding to inflation pressure, so we’d better raise rates further.

Chalmers has said the “stance” of fiscal policy adopted in the budget is “broadly neutral”. Not quite. So, I’ll say the nasty word Mr Nice Guy doesn’t want to: the stance is “mildly contractionary”.

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Monday, March 6, 2023

RBA inquiry should propose something much better

The inquiry into the Reserve Bank, due to report this month, will be disappointing if it does no more than suggest modest improvements in the way it does its job. The question it should answer is: should we give so much responsibility to an institution with such a limited instrument – interest rates – and with such a narrow focus?

In Reserve Bank governor Dr Philip Lowe’s lengthy appearance before the House of Representatives Economics Committee last month, he spent much of his time reminding critics that he only has one tool, so he can’t do anything to resolve the problems they were complaining about.

He’s right. But if the problems are real, and he can’t do anything about them, why should the central bank be the top dog when it comes to managing the economy, and Treasury’s job be limited to worrying about debt and deficit?

Shouldn’t the greatest responsibility go to an institution with more instruments, and ones capable of doing more tricks?

By the way, if you’re wondering why I’ve had so much to say recently about the limitations of monetary policy and the questionable convention of making it dominant in the management of the macroeconomy, it’s because it’s the obvious thing to do while we’re holding an inquiry into Reserve Bank’s performance.

Frenchman Olivier Blanchard, one of the world’s top macroeconomists, recently caused a storm when he tweeted about “a point which is often lost in discussions of inflation and central bank policy”.

“Inflation,” he wrote, “is fundamentally the outcome of the distributional conflict between firms, workers and taxpayers. It stops only when the various players are forced to accept the outcome.”

Oh, people cried, that can’t be right. Inflation is caused when the demand for goods and services exceeds the supply of them.

In truth, both propositions are correct. At the top level, inflation is simply about the imbalance between demand and supply. At a deeper level, however, “distributional conflict” between capital and labour can be the cause of that imbalance.

Businesses add to inflation when they seek to increase their profit margins. Workers and their unions add to inflation when they seek to increase their real wages by more than the productivity of labour justifies.

But this way of thinking is disconcerting to central bankers because – though there may well be a way of reducing inflation pressure by reducing the conflict between labour and capital – there’s nothing the Reserve can do about it directly.

Central banks’ interest-rate instrument can fix the problem only indirectly and brutally: by weakening demand (spending) until the warring parties are forced to suspend hostilities. So distributional conflict is the first thing monetary policy (the manipulation of interest rates) can’t really fix.

Then there’s inflation caused by other supply constraints, such as the pandemic or wars. Again, monetary policy can’t fix the constraint, just bash down demand to fit.

The next things monetary policy doesn’t do are fairness and effectiveness. When we’re trying to reduce inflation by reducing people’s ability to consume goods and services, it would be nice to do so with a tool that shared the burden widely and reasonably evenly.

A temporary increase in income tax or GST would do that, but increasing interest rates concentrates the burden on people with big mortgages. This concentration means the increase has to be that much greater to achieve the desired slowing in total consumer spending.

A further dimension of monetary policy’s unfairness is the way it mucks around with the income of savers. Their interest income suddenly dives when the Reserve decides it needs to encourage people to borrow and spend.

In theory, this is made up for when the Reserve decides to discourage people from borrowing and spending, as now. In practice, however, the banks drag their feet in passing higher interest rates on to their depositors. But it’s rare for the Reserve even to chivvy the banks for their tardiness.

Governments need to be free to encourage or discourage consumers from spending. But where’s the justification for doing this by riding on the backs of young people saving for a home and old people depending on interest income to live on?

The next thing monetary policy doesn’t do is competition. What’s supposed to keep prices no higher than they absolutely need to be is the strength of competition between businesses. You’d think this would be a matter of great interest to the Reserve, especially since there are signs that businesses increasing their “markups” are part of the present high inflation.

But only rarely does the Reserve mention the possibility, and only in passing. It gives no support to the Australian Competition and Consumer Commission’s efforts to limit big firms’ pricing power.

The final thing monetary policy doesn’t do is housing. The Reserve is right to insist that its increases in interest rates aren’t the main reason homes have become so hard to afford.

The real reason is the failure of governments to increase the supply of homes in the places people want to live – close to the centre of the city, where the jobs are – exacerbated by their failure to provide decent public transport to outer suburbs.

But the ups and downs of mortgage interest rates must surely be making affordability worse. To this, Lowe’s reply is that, sorry, he’s got a job to do and only one instrument to do it with, so he can’t be worried about the collateral damage he’s doing to would-be young home buyers.

Well, he can’t be worried, but his political masters can. And if they’re not game to fix the fundamental factors driving up house prices, they should be willing to create an instrument for the short-term management of demand that doesn’t cause as many adverse side effects as using interest rates does.

The one big thing going for monetary policy as a way of keeping the economy on track is that the Reserve’s independence of the elected government allows it to put the economy’s needs ahead of the government’s need to sync the economy with the next election.

But, as various respected economists have pointed out, there’s no reason the government can’t design a fiscal instrument, giving another body the ability to raise or lower it within a specified range, and making that body independent, too.

It’s the Reserve Bank inquiry’s job to give the government some advice on why and how it should make a change for the better.

Read more >>

Friday, March 3, 2023

Now the hard part for the RBA: when to stop braking

In economics, almost everything that happens has both an upside and a downside. The bad news this week is that the economy’s growth is slowing rapidly. The good news – particularly for people with mortgages and people hoping to keep their job for the next year or two – is that the slowdown is happening by design, as the Reserve Bank struggles to slow inflation, and this sign that its efforts are working may lead it to go easier on its intended further rises in interest rates.

But though it’s now clear the economy has begun a sharp slowdown, what’s not yet clear is whether the slowdown will keep going until it turns into a recession, with sharply rising unemployment.

As the Commonwealth Bank’s Gareth Aird has said, since the Reserve Bank board’s meeting early last month, when it suddenly signalled more rate rises to come, all the numbers we’ve seen – on economic growth, wages, employment, unemployment and the consumer price index – have all come in weaker than the money market was expecting.

What’s more, he says, only part of the Reserve’s 3.25 percentage-point rate increase so far had hit the cash flow of households with mortgages by the end of last year.

“There is a key risk now that the Reserve Bank will continue to tighten policy into an economy that is already showing sufficient signs of softening,” Aird said.

That’s no certainty, just a big risk of overdoing it. So while everyone’s making the Reserve’s governor, Dr Philip Lowe, Public Enemy No. 1, let me say that the strongest emotion I have about him is: I’m glad it’s you having to make the call, not me.

Don’t let all the jargon, statistics and mathematical models fool you. At times like this, managing the economy involves highly subjective judgments – having a good “feel” for what’s actually happening in the economy and about to happen. And it always helps to be lucky.

This week, the Australian Bureau of Statistics’ “national accounts” for the three months to the end of December showed real gross domestic product – the economy’s production of goods and services – growing by 0.5 per cent during the quarter, and by 2.7 per cent over the calendar year.

If you think 2.7 per cent doesn’t sound too bad, you’re right. But look at the run of quarterly growth: 0.9 per cent in the June quarter of last year, then 0.7 per cent, and now 0.5 per cent. See any pattern?

Let’s take a closer look at what produced that 0.5 per cent. For a start, the public sector’s spending on consumption (mainly the wage costs of public sector workers) and capital works made a negative contribution to real GDP growth during the quarter, thanks to a fall in spending on new infrastructure.

Home building activity fell by 0.9 per cent because a fall in renovations more than countered a rise in new home building.

Business investment spending fell by 1.4 per cent, pulled down by reduced non-residential construction and engineering construction. A slower rate of growth in business inventories subtracted 0.5 percentage points from overall growth in GDP.

So, what was left to make a positive contribution to growth in the quarter? Well, the volume (quantity) of our exports contributed 0.2 percentage points. Mining was up and so were our “exports” of services to visiting tourists and overseas students.

But get this: a 4.3 per cent fall in the volume of our imports of goods and services made a positive contribution to overall growth of 0.9 percentage points.

Huh? That’s because our imports make a negative contribution to GDP, since we didn’t make them. (And, in case you’ve forgotten, two negatives make a positive – a negative contribution was reduced.)

So, the amazing news is that the main thing causing the economy to grow in the December quarter was a big fall in imports – which is just what you’d expect to see in an economy in which spending was slowing.

I’ve left the most important to last: what happened to consumer spending by the nation’s 10 million-odd households? It’s the most important because it accounts for about half of total spending, because it’s consumer spending that the Reserve Bank most wants to slow – and also because the economy exists to serve the needs of people, almost all of whom live in households.

So, what happened? Consumer spending grew by a super-weak 0.3 per cent, despite growing by 1 per cent in the previous quarter. But what happened to households and their income that prompted them to slow their spending to a trickle?

Household disposable income – which is income from wages and all other sources, less interest paid and income tax paid by households – fell 0.7 per cent, despite a solid 2.1 per cent increase in wage income – which reflected pay rises, higher employment, higher hours worked, bonuses and retention payments.

But that was more than countered by higher income tax payments (as wages rose, with some workers pushed into higher tax brackets) and, of course, higher interest payments.

All that’s before you allow for inflation. Real household disposable income fell by 2.4 per cent in the quarter – the fifth consecutive quarterly decline.

That’s mainly because consumer prices have been rising a lot faster than wages. So, falling real wages are a big reason real household disposable income has been falling, not just rising interest rates.

Real disposable income has now fallen by 5.4 per cent since its peak in September quarter, 2021.

But hang on. If real income fell in the latest quarter, how were households able to increase their consumption spending, even by as little as 0.3 per cent? They cut the proportion of household income they saved rather than spent from 7.1 per cent to an unusually low 4.5 per cent.

If I were running the Reserve, I wouldn’t be too worried about strong consumer spending stopping inflation from coming down.

Read more >>

Monday, February 27, 2023

The rich world should think twice about 'central bankism'

For the best part of 30 years, the governments of the advanced countries have outsourced the management of their economies to independent central banks. For many of those years, this change looked to have been a smart one. Now, not so much.

If the central banks’ efforts to get on top of the huge and quite unexpected surge in inflation that followed the pandemic go too far, and the rich countries end up in a severe recession, the inevitable search for someone to blame will lead straight to the door of the central bank.

After all, it was the central bank that, ignoring all the cries of pain, insisted on raising interest rates as far and fast as it did. And, as would by then be obvious, it misjudged and went too far.

It ignored the first rule for econocrats using a policy tool notorious for its “long and variable lags”: if you keep tightening until you’re sure you’ve got inflation beat, you’re sure to have gone too far.

You kept telling us it wasn’t your intention to cause a recession, but we got one anyway. So, were you lying to us, or just incompetent?

That’s my first point: if we do end up in recession, the independent central banks will get the blame, and there’ll be a posse of angry voters around the world demanding they be stripped of their independence.

But even if – as we hope - the worst doesn’t come to the worst, there’ll still be a strong case for our politicians to ask the obvious question: surely there must be a better way to run a railroad?

The rich world moved to central bank independence in the 1990s for strictly pragmatic reasons: because governments couldn’t be trusted to move the interest rate lever up and down to fit the economic cycle, not the political cycle.

Fine. But this is a democracy. How come a bunch of unelected bureaucrats have been given so much power? The fact is, independent central banking’s legitimacy comes solely because a duly elected government saw fit to grant it that freedom, and the present government hasn’t seen fit to take it away. Yet.

The trick is, if a central bank really stuffs up, voters will be furious, and they’ll turn on the only people they can turn on: the government of the day. You may think that, should a government of one colour be tossed out because of the central bank’s almighty stuff-up, the incoming government of the other colour would be mighty pleased with the central bank.

No way. What it would think is: if those bastards could do it to the others, they could just as easily do it to us. The new government’s first act would be to clip the central bankers’ wings.

The broader point is that independent central banking was not ordained by God. It’s just a policy choice we made at a time when it seemed like a good idea. When circumstances change, and we realise it wasn’t such a good idea, we’ll be perfectly equipped and entitled to change to a different policy arrangement we hope will work better.

Of course, moving away from economic management by interest-rate manipulation wouldn’t please everyone. It wouldn’t please academic economists who’d devoted their lives to the study of monetary economics (and right now, are hoping for a well-paid spot on the Reserve Bank board).

Nor would it suit the industry that, over the past 30 years, has grown up on the pavement outside the central bank’s building, so to speak. All the money market dealers who make their living betting on whether the central bank will change rates this month and by how much. Nor the economists who write the professional punters’ tip sheets.

And it’s a safe bet it wouldn’t suit the big banks, who’d much prefer the economy to be run by their mates down the road in Martin Place, rather than all those unknown bureaucrats and politicians in Canberra.

When you let one institution run the economy day to day for so long, it starts to get proprietorial. It’s in change of the economy and, when problems arise, it must be the outfit that takes charge and does what’s necessary to fix things.

There’s never a time when you admit that some other institution – the government and its Treasury advisers, for instance – should take the running because their instrument, the budget, is more multifaceted and suited to the problem than is your one-trick-pony instrument, interest rates.

And you do this even when the official interest rate is not far above zero. You tell everyone who thinks you’re out of ammo and should leave the running to Treasury and fiscal policy, they’re wrong, and resort to quantitative easing and other “unconventional measures”.

I reckon a big part of the reason what we thought was a problem of holding the economy together while we dealt with the pandemic turned into the worst inflationary episode in 30 years was the uncalled-for intervention of central banks, pushing themselves to the front of the fiscal parade.

And this from the institution that’s spend decades telling us it knows more about inflation than everyone else, cares more about inflation than anything else, and accepts ultimate responsibility to protect us from the supreme evil of inflation.

Today’s conventional wisdom says the present inflation surge was caused by big pandemic and war-caused supply shortages coming at a time when demand had been overstimulated. But a big part of that overstimulation occurred because central banks insisted on coming in over the top of those who were better equipped to respond to the pandemic and, indeed, were responsible for ordering and policing the lockdowns: the federal and state governments.

In Australia, nowhere was this overkill more apparent than in housing. While both federal and state governments were instituting temporary incentives to encourage home building, the central bank was not only slashing the official interest rate to near zero, it was lending to the banks at a hugely concessional rate, and buying second-hand government bonds, so the banks could offer home buyers two and three-year fixed-interest loans.

Throw in a temporary, pandemic-caused shortage of imported building materials, and you have much of our inflation surge being explained by an astonishing 27 per cent leap in the cost of a newly built home.

Why wasn’t there any co-ordination between the three arms of government that caused this avoidable inflationary disaster? Because the central bank is independent. It acts on its own volition.

But also because, when your only tool is a one-trick pony, you end up wearing blinkers. When you can only join the game by putting rates up or putting them down, you just can’t afford to worry about anyone who may be sideswiped in the process.

Read more >>

Monday, February 20, 2023

Central banking: don't mention business pricing power

Despite the grilling he got in two separate parliamentary hearings last week, Reserve Bank governor Dr Philip Lowe’s explanation of why he was preparing mortgage borrowers for yet further interest rate increases didn’t quite add up. There seemed to be something he wasn’t telling us – and I think I know what it was.

We know that, as well as rising mortgage payments, we have falling real wages, falling house prices and a weak world economy. So it’s not hard to believe the Reserve’s forecasts that the economy will slow sharply this year and next, unemployment will rise (it already is), and underlying inflation will be back down to the top of the 2 per cent to 3 per cent target range by the end of next year.

So, why is Lowe still so anxious? Because, he says, it’s just so important that the present high rate of inflation doesn’t become “ingrained”. “If inflation does become ingrained in people’s expectations, bringing it back down again is very costly,” he said on Friday.

Why is what people expect to happen to inflation so crucial? Because their expectations about inflation have a tendency to be self-fulfilling.

When businesses expect prices to keep on increasing rapidly, they keep raising their own prices. And when workers and their unions expect further rapid price rises, they keep demanding and receiving big pay rises.

This notion that, once people start expecting the present jump in inflation to persist, it becomes “ingrained” and then can’t be countered without a deep recession has been “ingrained” in the conventional wisdom of macroeconomists since the 1970s.

They call it the “wage-price spiral” – thus implying it’s always those greedy unionists who threw the first punch that started the brawl.

In the 1970s and 1980s, there was a lot of truth to that characterisation. In those days, many unions did have the industrial muscle to force employers to agree to big pay rises if they didn’t want their business seriously disrupted.

But that’s obviously not an accurate depiction of what’s happening now. The present inflationary episode has seen businesses large and small greatly increasing their prices to cover the jump in their input costs arising from pandemic-caused supply disruptions and the Ukraine war.

Although the rate of increase in wages is a couple of percentage points higher than it was, this has fallen far short of the 5 or 6 percentage-point further rise in consumer prices.

So Lowe has reversed the name of the problem to a “prices-wages spiral”. In announcing this month’s rate rise, he said that “given the importance of avoiding a prices-wages spiral, the board will continue to play close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead”.

Lowe admits that inflation expectations, the thing that could set off a prices-wages spiral, have not risen. “Medium-term inflation expectations remain well anchored,” but adds “it is important that this remains the case”.

If that’s his big worry, Treasury secretary Dr Steven Kennedy doesn’t share it. Last week he said bluntly that “the risk of a price and wage spiral remains low, with medium-term inflation expectations well anchored to the inflation target.

“Although measures of spare capacity in the labour market show that the market remains tight, the forecast pick-up in wages growth to around 4 per cent is consistent with the inflation target.”

So, why does Lowe remain so concerned about inflation expectations leading to a prices-wages spiral that he expects he’ll have to keep raising the official interest rate?

There must be something he’s not telling us. I think his puzzling preoccupation with inflation expectations is a cover for his real worry: oligopolistic pricing power.

Why doesn’t he want to talk about it? Well, one reason could be that the previous government has given him a board stacked with business people.

A better explanation is that he’s reluctant to admit a cause of inflation that’s not simply a matter of ensuring the demand for goods and services isn’t growing faster than their supply.

Decades of big firms taking over smaller firms and finding ways to discourage new firms from entering the industry has left many of our markets for particular products dominated by two, three or four huge companies – “oligopoly”.

The simple economic model lodged in the heads of central bankers assumes that no firm in the industry is big enough to influence the market price. But the whole point of oligopoly is for firms to become big enough to influence the prices they can charge.

When there are just a few big firms, it isn’t hard for them reach a tacit agreement to put their prices up at the same time and by a similar amount. They compete for market share, but they avoid competing on price.

To some degree, they can increase their prices even when demand isn’t strong, or keep their prices high even when demand is very weak.

I suspect what’s worrying Lowe is his fear that our big firms will be able keep raising their prices even though his higher interest rates have greatly weakened demand. If so, his only way to get inflation back to the target band will be to keep raising rates until he “crunches” the economy and forces even the big boys to pull their horns in.

It’s hard to know how much of the surge in prices we saw last year was firms using their need to pass on to customers the rise in their input costs as cover for fattening their profit margins.

We do know that Treasury has found evidence of rising profit margins – “mark-ups”, as economists say – in Australia in recent decades.

And a study by the Federal Reserve Bank of Kansas City has found that mark-ups in the US grew by 3.4 per cent in 2021.

But for Lowe (and his predecessors, and peers in other central banks) to spell all that out is to admit there’s an important dimension of inflation that’s beyond the direct control of the central banks.

If he did that, he could be asked what he’s been doing about the inflation caused by inadequate competition. He’d say competition policy was the responsibility of the Australian Competition and Consumer Commission, not the Reserve. True, but what an admission.

In truth, the only person campaigning on the need to tighten competition policy in the interests of lower inflation is the former ACCC chair, Professor Rod Sims. Has he had a shred of public support from Lowe or Kennedy? No.

Final point: what’s the most glaring case of oligopolistic pricing power in the country? The four big banks. Since the Reserve began raising interest rates, their already fat profits have soared.

Why? Because they’ve lost little time in passing the increases on to their borrowing customers, but been much slower to pass the increase through to their depositors. Has Lowe been taking them to task? No, far from it.

But his predecessors did the same – as no doubt will his successors, unless we stop leaving inflation solely to a central bank whose only tool is to fiddle with interest rates.

Read more >>

Friday, February 17, 2023

Inflation is too tricky to be left to the Reserve Bank

The higher the world’s central banks lift interest rates, and the more they risk pushing us into recession, the more our smarter economists are thinking there has to be a better way to control inflation.

Unsurprisingly, one of the first Australian economists to start thinking this way is our most visionary economist, Professor Ross Garnaut. He expressed his concerns in his book Reset, published in early 2021.

Then, just before last year’s job summit, he gave a little-noticed lecture, “The Economic Consequences of Mr Lowe” – a play on a famous essay by Keynes, “The Economic Consequences of Mr Churchill”.

Academic economists are rewarded by their peers for thinking orthodox thoughts, and have trouble getting unorthodox thoughts published. Trick is, it’s the people who successfully challenge the old orthodoxy who establish the new orthodoxy and become famous. John Maynard Keynes, for instance.

In his lecture, Garnaut praised the Australian econocrats who, in the late 1940s, supervised the “postwar reconstruction”. They articulated “an inclusive vision of a prosperous and fair society, in which equitable distribution [of income] was a centrally important objective”.

The then econocrats’ vision “was based on sound economic analysis, prepared to break the boundaries of orthodoxy if an alternative path was shown to be better”.

It culminated in the then-radical White Paper on full employment, of 1945, under which policy the rate of unemployment stayed below 2 per cent until the early 1970s.

Garnaut’s earlier criticism of the Reserve was its unwillingness to keep the economy growing strongly to see how far unemployment could fall before this led to rising inflation. “We haven’t reached full employment [because] the Reserve Bank gave up on full employment before we got there.”

Now, Garnaut’s worry is that “monetary orthodoxy could lead us to rising unemployment without good purpose”.

“Monetary orthodoxy as it has developed in the 21st century leads to a knee-jerk tendency towards increased interest rates when the rate of inflation... rises.

“I have been worried about the rigidity of the new monetary orthodoxy since the early days of the China resources boom.” He had “expressed concern that an inflation standard was replacing the gold standard as a source of rigidity in monetary policy”.

Ah. That’s where his allusion to Churchill comes in. In 1925, when he was Britain’s chancellor of the exchequer, Churchill made “the worst-ever error of British monetary policy” by following conventional advice to suppress the inflationary consequences of Britain’s massive spending on World War I by returning sterling to the “gold standard” (Google it) at its prewar parity.

The consequence was to plunge Britain into deep depression years before the Great Depression arrived.

“If we continue to tighten monetary policy – raise interest rates – because inflation is higher that the target range, then we will diminish demand... in ways that seriously disrupt the economy.

“High inflation is undesirable, and it is important to avoid entrenched high inflation. But not all inflation is entrenched at high levels. And inflation is not the only undesirable economic condition.

“There is a danger that we will replace continuing improvement to full employment with rising unemployment – perhaps sustained unnecessarily high unemployment.

“That would be a dreadful mistake. A mistake to be avoided with thoughtful policy.”

Such as? Garnaut has two big alternative ways of reducing inflation.

First, whereas in the early 1990s there was a case for independence of the Reserve Bank because, with high inflation entrenched, it needed to do some very hard things, he said, “what we now need is an independent authority looking at overall demand, and not just monetary policy.

“We need an independent body playing a role in both fiscal and monetary policy... It would be able to raise or lower overall tax rates in response to the macroeconomic situation.”

Second, we shouldn’t be using higher interest rates to respond to the surge in electricity and gas prices caused by the invasion of Ukraine.

Because of the way we’ve set up our energy markets, the increases in international prices came directly back into Australian prices. This put us in the paradoxical position of being the world’s biggest exporter of liquified natural gas and coal, taken together, but most Australians became poorer when gas and coal prices increased.

“Many Australians find this difficult to understand. If they understand it, they find it difficult to accept.

“Actually, it’s reasonable for them to find it unacceptable,” he said.

So, what to do? We must “insulate the Australian standard of living from those very large increases in coal, gas and therefore electricity”.

How? One way is to cause domestic energy prices to be lower than world prices. The other is to leave prices as they are, but tax the “windfall profits” to Australian producers caused by the war, then use those profits to make payments to Australian households – and, where appropriate, businesses – to insulate them from this price increase.

By causing actual prices to be lower, the first way leaves the Reserve less tempted to keep raising interest rates. Which, in turn, should avoid some unnecessary increase in unemployment.

There are two ways to keep domestic prices lower than world (and export) prices. One is to limit exports of gas and coal to the extent needed to stop domestic prices rising above what they were before the invasion.

The other way is to put an export levy (tax) on coal and gas, set to absorb the war-cause price increase.

Either of these methods could work, Garnaut said. Western Australia’s “domestic reservation requirement” specifying the amount of gas exporters must supply to the local WA market, has worked well – but this would be hard to do for coal.

This week Treasury secretary Dr Steven Kennedy said the measures the government actually decided on could reduce the inflation rate by three-quarters of a percentage point over this year.

Garnaut’s point is that we’ll end up with less unemployment if we don’t continue leaving the whole responsibility for inflation to an institution whose only tool is to wack up interest rates.

Read more >>

Wednesday, February 15, 2023

It's no wonder the young hate Boomers like me

As I get older, more parts of my body are giving me gyp and I spend more of my life seeing doctors, but the people I don’t envy are the young. They may be fit and keen, but everywhere they look they see problems.

The big advantage of capitalism is supposed to be that it makes each generation better off than the last. But that’s breaking down before our eyes. The really harmful problem we’re leaving them is climate change, of course, but there’s much more than that.

They’re better educated than ever but, for many, it doesn’t seem to get them a secure, decently paid job. Even so, they leave education owing big debts to the government.

But, coming well behind climate change, the biggest disservice the older generation has done to them is to let the price of a home keep reaching for the sky.

We’re now at the point where each successive age group contains an ever-lower proportion of people who’ve managed to buy the home they live in.

In contrast, the aged have never had it better. The only thing they have to fear – and the young have to look forward to – is still needing to rent privately in retirement.

We’ve turned housing into Lotto. If you manage to win, they shower you in wealth. If you don’t win, you get screwed. Renters have few rights because, as we all know, it’s just a temporary state for the young.

And then the Baby Boomers (like me) wonder why the young seem to hate them. It’s not true that all Baby Boomers are rolling in it. Some of them don’t even own their own home. But most of them (like me) were able to buy early in their lives, when first homes were affordable. Since then, they’ve just sat back in delighted amazement as their wealth has multiplied.

Of course, if there’s anything wrong with the way the world’s run, it wasn’t anything I did, it was those terrible pollies. Yeah, nah.

Since older home owners have always far out-numbered the young would-be home owners, the politicians have always run the housing game to favour those who love seeing property prices rise – and, now you mention it, wouldn’t mind buying another house as an investment.

At present, it’s easy to conclude the big problem with housing affordability is rising interest rates and so blame it all on the Reserve Bank boss Dr Philip Lowe. But, as I’ve written elsewhere, although it’s reasonable to ask whether putting interest rates up and down is a sensible and fair way to manage the economy, that’s a separate issue.

Home loans take two to tango: how much you have to borrow and the interest rate on the loan. The interest rate cycles up and down around a relatively stable average, whereas the amount you need to borrow has gone up and up, decade after decade.

True, house prices are falling at present, but this is just returning them to where they were before they took off during the pandemic. It’s a safe bet that, once they’ve finished falling, they’ll resume their upward climb.

This is why oldies are wrong to scoff at young people complaining about mortgage interest rates of 5 per cent. “In my day, I had to pay 17 per cent!” Yes, you did – for a year or so in the early 1990s, when the amount you had to borrow was much less.

What’s true is that, right now, it’s mainly younger people who borrowed huge sums in the past few years who’re really feeling the pain.

But the real question is why house prices have risen so far for so long. They’ve risen much faster than incomes. The Grattan Institute calculates that whereas typical house prices used to be about four times incomes, now they’re more than eight times – and even more in Melbourne and Sydney.

But why? Not because of anything the Reserve Bank has done. Nor so much because we’ve failed to build enough additional houses and units to accommodate the growth in the population.

More because our tax and social security rules have made home ownership a highly attractive, government-favoured form of investment, not just a place you can call your own and not be chucked out of as long you keep up the payments. People who buy investment properties out-compete would-be first home owners, bidding up the price.

But also because there’s more competition to buy homes in particularly desirable areas. Spots near the beach or the river, for instance, but also places near where the jobs are.

People have been crowding into the big cities, trying to get close to the CBD with all its well-paid office jobs, but the older home owners fight hard to discourage governments from making room for younger newcomers. “It’s so ugly.”

And the bank of mum and dad (yes, I’ve done it) is helping prices stay high, while widening the divide between those young people with well-placed parents and those without.

Read more >>

Sunday, February 12, 2023

Interest rates: Lowe's not the problem, the system is rotten

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.

Read more >>

Monday, November 7, 2022

The cost of living isn't as high as we've been told

So, as we learnt the day after the budget, the cost of living leapt by 7.3 per cent over the past year, right? Wrong. Last week we were told it’s gone up no more than 6.7 per cent for employees, and 6.4 per cent for pensioners and others on benefits.

The 7.3 per cent came from the Australian Bureau of Statistics, and was the rise in the consumer price index over the year to the end of September. The other figures also came from the bureau, and were for the rise in the “living cost index” over the same period for certain types of households.

Why weren’t you told about the second lot? Because the media wanted to avoid confusing you – and because they were better news rather than worse.

Huh? What’s going on? We’re used to using the consumer price index (CPI) as a measure of the cost of living. But the bureau knows it’s not. So, a week later, it always issues its living-cost indexes for key household types – which the media always ignore.

Usually, the differences from the CPI aren’t big enough to worry about. But now they are. Why? Because mortgage interest rates are increasing rapidly. And mortgage interest charges are the main difference between the two measures.

Before late-1998, the CPI measured the housing costs of owner-occupiers according to the interest they paid on their mortgages. But this was changed at the behest of the Reserve Bank, which didn’t want its measure of inflation to go up every time it raised interest rates to get inflation down.

So, since then, the bureau has measured owner-occupiers’ housing costs by taking the price of building a new house or unit. This doesn’t make much sense, since not many people buy a newly built home each quarter. Many of us have never bought a newly built home.

This is why the bureau also calculates separate cost of living indexes, using the same prices as the CPI, but restoring mortgage interest charges, as well as giving the prices different weights to take account of the differing spending patterns of particular household types, such as age pensioners.

New dwelling prices rose by almost 21 per cent over the year to September, meaning they accounted for a quarter of the 7.3 per cent rise in the CPI. By contrast, the mortgage interest charges paid by employee households rose by more than 23 per cent, but contributed only 12 per cent (0.8 percentage points) of the 6.7 per cent rise in their total costs.

Get it? Since mortgage interest charges are a more accurate guide to the costs of owner-occupiers than new-home prices are, the CPI is significantly overstating the rise in the living costs of everyone, from employees to people on social security (and the self-proclaimed “self-funded” retirees, for that matter).

This is a sliver of good news about the extent of cost-of-living pressure on households. It’s better news for people on indexed pensions and benefits: they’ll get what amounts to a small real increase.

But it raises an obvious question: why on earth has the cost of newly built homes shot up by 21 per cent over the past year? After all, this has added hugely to the Reserve Bank’s need to fight inflation by raising interest rates, to the tune of 2.75 percentage points so far.

It’s true the pandemic has caused shortages of imported building materials, but the real blame is down to the economic mangers’ appalling own goal in using grants, tax breaks and cuts in interest rates to rev up the home building industry far beyond its capacity to expand.

It got a huge pipeline of unfilled orders and whacked up its prices, adding no less than a quarter to our soaring inflation rate. Well done, guys.

This raises a less obvious question: federal and state governments were spending unprecedented billions to hold the economy together during the pandemic and its lockdowns. With the official interest rate already down to 0.75 per cent without doing much good, was it really necessary to cut the rate to 0.1 per cent and engage in all that unconventional money creation?

It makes a good case for the new view that, while monetary policy works well when you want to slow demand, it doesn’t work well when you wish to speed it up. Especially when rates are already so low and households already so heavily indebted.

This is something those reviewing the Reserve Bank should be considering.

Read more >>

Friday, November 4, 2022

Labor will struggle with deficit and debt until it raises taxes

There’s something strange about last week’s federal budget. It reveals remarkably quick progress in getting the budget deficit down to nearly nothing. But then it sees the deficit going back up again. Which shows that, as my former fellow economics editor Tim Colebatch has put it, Rome wasn’t built in one budget.

Let’s look at the figures before explaining how they came about. The previous, Coalition government finally got the budget back to balance in the last full financial year before the arrival of the pandemic, 2018-19.

The government’s big spending and tax breaks in response to COVID’s arrival in the second half of the following year, 2019-20, saw the budget back in deficit to the tune of $85 billion. Next year’s deficit was even higher at $134 billion.

But in the year that ended soon after the change of government in May, 2021-22, the deficit fell to just $32 billion. And in last week’s second go at the budget for this year, 2022-23, the deficit is expected to be little changed at $37 billion – which would be $41 billion less than what Scott Morrison was expecting at the time of the election six months ago.

But the changes in these dollar figures don’t tell us much as comparing the size of the deficit with the size of the economy (nominal gross domestic product) in the same year. Judging it this way allows for the effect of inflation and for growth in the population.

So, relative to GDP, the budget deficit has gone from zero in 2018-19, to 4.3 per cent, then a peak of 6.5 per cent in 2020-21, then crashed down to just 1.4 per cent last financial year. This year’s deficit is now expected to be little changed at 1.5 per cent.

We all know why the deficit blew out the way it did, but why did it come back down so quickly?

Three main reasons. The biggest is that it happened by design. All the pandemic-related measures were temporary. As soon as possible, they were ended.

But also: the rise in world fossil fuel prices caused by the war in Europe produced a huge surge tax collections from our mining companies. Last week’s budget announced the new government’s decision to use almost all of this windfall to reduce the deficit.

And last week we learnt the government had also decided to keep a very tight rein on government spending. It introduced all the new spending programs it promised at the election, but cut back the previous government’s programs to largely cover the cost of the new ones.

Its frugality had one objective: to help the Reserve Bank reduce inflation by first using higher interest rates to reduce people’s demand for goods and services.

Keeping the deficit low for another year has, Treasurer Jim Chalmers said this week, changed the “stance” of fiscal (budgetary) policy to “broadly neutral” - neither expansionary nor contractionary. Which, he’s sure to be hoping, will mean the Reserve has to raise interest rates by less than would have.

Another benefit of his decision not to spend the tax windfall, Chalmers said this week, is that by June next year, the government’s gross debt will be $50 billion lower than it would have been. And, according to Treasury’s calculations, this reduction means a saving of $47 billion on interest payments over the decade to 2033.

Great. Wonderful. Except for the strange bit: two years after this financial year, the budget deficit is expected to have gone back up to $51 billion, or 2 per cent of GDP.

What’s more, the budget’s “medium-term projections” foresee the deficit stuck at about 2 per cent each year – or $50 billion in today’s dollars – for the following eight years to 2032-33.

In the first budget for this year, just before the election, the deficit was projected to have fallen slowly to 0.7 per cent of GDP by 2033. Now, no progress is expected. Which means, of course, that the amount of public debt we end up with will be higher than expected during the election campaign.

The gross public debt is now not expected to reach a plateau, of about 47 per cent of GDP, until the first few years of the 2030s.

So, if the budget deficits last year and this are so much better than we were expecting just seven months ago, why on earth are the last eight years of the medium term now expected to be significantly worse?

Three main reasons. First, because a new actuarial assessment of the future cost of the National Disability Insurance Scheme (NDIS) shows the cost growing much faster than previously thought.

Second, because, with world interest rates having risen so much this year, the interest bill on the public debt is now projected to be much bigger over the coming decade.

Third, because the previous government based its projections on the assumption that the productivity of labour would improve at the quite unrealistic average rate of 1.5 per cent a year, but Chalmers has cut this to a more realistic 1.2 per cent. This change reduces government revenue by more than it reduces government spending.

What this exercise reveals is that the “persistent structural deficit” earlier projections told us to expect, will actually be worse than we were told. The deficit won’t go away but, on present policies, will stay too high every year for as far as the eye can see.

Fortunately, Chalmers freely admits that present policies will have to be changed. “While this budget has begun the critical task of budget repair, further work will be required in future budgets to rebuild fiscal buffers [ready for the next recession] and manage growing cost pressures”.

He repeated this week his view that, as a country, we need to “have a conversation about what we can afford and what we can’t” - his way of breaking it gently that, if the structural deficit is to be removed, taxes will have to rise.

Read more >>

Monday, October 31, 2022

Memo RBA board: Time to stop digging in deeper on interest rates

If, as seems likely, the combined might of the advanced economies’ central banks pushes the world into recession, the biggest risk isn’t that they’ll drag us down too, but that our Reserve Bank will raise our own interest rates too far.

That’s the message to us – and everyone else – from the International Monetary Fund’s repeated warnings about the unexpected consequences of “synchronised tighten” by the big economies – America, Europe and, in its own way, China, all jamming on the brakes at the same time.

Synchronised macro-policy shifts are a relatively new problem in our more globalised world economy. Until the global financial crisis of 2008, world recessions tended to roll from one country to the next. Since then, everyone tends to start contracting – or stimulating – at the same time.

When you were stimulating while your trading partners weren’t, much of your stimulus would “leak” to their economies, via your higher imports. But, as we learnt in the fight to counter the Great Recession, when everyone’s stimulating together, your leakage to them is offset by their leakage to you, thus making your stimulus stronger than you were expecting.

The fund’s warning is that we’re now about to learn that the same thing happens in reverse when everyone’s hitting the brakes – budgetary as well as monetary – together. Synchronisation will make your efforts to restrain demand (spending on goods and services) more potent than you were expecting.

So the fund’s message to us is: when you’re judging how high interest rates have to go to get inflation heading back down to the target, err on of side to doing too little.

But there are four other factors saying the Reserve should be wary of pushing rates higher. The first is Treasurer Jim Chalmers’ confirmation in last week’s budget that the “stance” of his fiscal policy has also switched from expansionary to restrictive, and so is now adding to the restraint coming from tighter monetary policy.

Chalmers has cut back the Coalition’s spending programs to make room for Labor’s new spending plans, while “banking” the temporary surge in tax revenue arising from the war-caused jump in world energy prices, and the success of the Coalition’s efforts to return us to full employment.

As a result, the budget deficit has fallen from a peak of $134 billion (equivalent to 6.5 per cent of gross domestic product) in 2020-21, to $32 billion (1.4 per cent) in the year to this June. The present financial year should see that progress largely retained, with the deficit rising only a little.

What’s more, the government’s already acting on its intention to force our greedy gas producers to raise their prices by a lot less than has been assumed in the budget’s inflation forecasts.

Second, the Reserve’s efforts to reduce aggregate (total) demand by using the higher cost of borrowing to reduce domestic demand, will be added to by the other central banks’ efforts to reduce our “net external demand” (exports minus imports).

What’s more, the expected further big fall in house prices will help reduce domestic demand by making home owners feel a lot less well-off than they were (the “wealth effect”).

Third – and this is a big point – the restrictive effect of the Reserve’s higher interest rates will be massively reinforced by the “cost-of-living squeeze” (aka the huge fall in real wages). Comparing the wage price index with the consumer price index, real wages fell by 2 per cent over the year to June 2021, and by an unbelievable 3.5 per cent to June this year.

Now the budget’s predicting a further fall of 2 per cent to June next year, with only the tiniest gain by June 2024.

This is an unprecedented blow to households’ income. It just about guarantees an imminent return to weak consumer spending. And it’s a much bigger blow than the big advanced economies have suffered, suggesting our central bank should be going easier on rate rises than theirs.

The final factor saying the Reserve should be wary of pushing rates higher is “lags”. As top international economist Olivier Blanchard reminded us in a recent Twitter thread, monetary policy affects the inflation rate with a variable delay of maybe six to 18 months.

This says you should stop tightening about a year before you see any hard evidence that inflation has peaked and started falling. Wait for that evidence, and you’re certain to have hit the economy too hard, causing the recession we didn’t have to have.

But to stop tightening before the money market know-alls think you should takes great courage.

Read more >>

Friday, October 28, 2022

Budget will reduce need for increases in interest rates

When the economy’s needs have switched from stimulus to restraint, it helps to get in new economic managers, who can reverse their predecessors’ direction with zeal rather than embarrassment.

The need for economic policy to change course became clear only during this year’s election campaign, when the Reserve Bank’s concern about rapidly rising inflation prompted it to make the first of many rises in the official interest rate.

So this week’s second go at a budget for the present financial year was needed not just to accommodate a new government with different policies and preferences, but to change the budget’s direction from push-forward, to pull-back.

In just those few months, we changed from “gee, aren’t we roaring along” to “gosh, we better slow down quick”. One moment we’re seeing how low we can get the rate of unemployment, the next we’re jacking up interest rates in a struggle to get inflation down.

A drawback of living in a market economy is that it moves through a “business cycle” of alternating boom and bust. The role of the economic managers is to “stabilise” – or smooth out - the demand for goods and services, cutting off the peaks and filling in the troughs.

The problem with booms is that as demand (spending) starts running ahead of supply (production), it pushes up prices and the inflation rate. The problem with troughs is that as demand falls behind supply, businesses start sacking workers and unemployment rises.

The macro managers use two “instruments” to smooth the cycle’s ups and downs: the budget (“fiscal policy”) and interest rates (“monetary policy”).

With the budget, they increase government spending and cut taxes to add to demand and so reduce unemployment. They cut government spending and increase taxes to reduce demand and so reduce the rate of inflation.

With interest rates, the Reserve Bank cuts them to encourage borrowing and spending by households, so as to reduce unemployment. It increases them to discourage borrowing and spending by households and so reduce inflation.

So, which of the two policy levers should you use?

A new conventional wisdom has emerged among top American academic economists that, because of the two levers’ contrasting strengths and weaknesses – and because interest rates are so much closer to zero than they used to be - you should use fiscal policy to boost demand, but monetary policy to hold it back.

This more discriminating approach has yet to become the accepted wisdom, however. The old wisdom is that monetary policy is the better tool to use for both stimulus and restriction.

The budget’s “automatic stabilisers” (mainly bracket creep and unemployment benefits) should be free to help monetary policy in its “counter-cyclical” role, but discretionary, politician-caused changes in government spending and taxes should be used only in emergencies, such as recessions.

So expansionary fiscal policy did much of the heavy lifting during the pandemic – hence the huge budget deficits and addition to government debt.

But now the Reserve and monetary policy have taken the lead in slowing demand within Australia, so it doesn’t add to the higher prices we’re importing from abroad, thanks to the pandemic-caused supply chain disruptions and the Russian-war-caused leap in fuel prices.

The conventional wisdom also says that, whatever you do, never have the two policy tools pulling in opposite directions rather than together.

If you’re mad enough to have the budget strengthening demand when the independent central bank wants it to weaken, all you do is prompt the bankers to lift interest rates that much higher. This is the “monetary policy reaction function”. One way of saying the central bankers always have the trump card.

Which brings us to this week’s budget redux. How did Treasurer Jim Chalmers play his cards? He did what he thought he could to get the budget deficit as low as possible and so back up monetary policy’s efforts to reduce demand. He’s no doubt hoping this will reduce the need for many more interest-rate increases.

First, Finance Minister Katy Gallagher hacked away at the Morrison government’s new spending programs, so that Labor’s promised new spending could take their place with little net addition to expected government spending over this financial year and the following three.

This wasn’t particularly hard because most of the Coalition’s plans were politically driven, and most hadn’t got going before government changed hands in May.

Second, the same attack on Ukraine that’s causing household electricity and gas bills to rocket has also caused the profits of Australian gas and coal exporters to rocket, along with their company tax bills.

As well, the Coalition’s success in getting employment up and unemployment down has caused a surge in income tax collections.

This huge boost to government revenue isn’t expected to last, so Chalmers has decided to “bank” almost all of it rather than spend it. That is, use it to reduce the budget deficit.

The budget in March expected a budget deficit for the year to this June of $80 billion. Thanks mainly to the tax windfall, it came in at $32 billion, a huge improvement, equivalent to more than 2 per cent of gross domestic product.

The deficit for this year was expected to be $78 billion, but now $37 billion is expected, an improvement of almost 2 per cent of GDP. Next financial year, 2023-24, has gone from $57 billion to $44 billion.

So, the budget deficit is expected to fall continuously from a peak of $134 billion (6.5 per cent of GDP) in 2020-21 to $37 billion (1.5 per cent) this financial year.

That’s enough to convince me the “stance” of fiscal policy is now restrictive. I reckon it’s also enough to convince Reserve Bank governor Dr Philip Lowe that fiscal policy is co-operating in the effort to restrain demand and control inflation.

One small problem. After this year, the deficit’s projected to start drifting back up, and stay at about 2 per cent of GDP until at least 2032-33.

Oh dear. Why? Tell you next week.

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Tuesday, October 25, 2022

Join the dots: your taxes are heading up, not down

Treasurer Jim Chalmers’ “solid and sensible” budget is not so much good or bad as incomplete. It hints at “hard decisions” to be made but doesn’t make them. It tells us times are tough and getting tougher – which we already knew. What we don’t know is what the government plans to do about it. We were told some things, but one big gap remains.

Chalmers said the budget’s priority was to provide cost-of-living relief. No, not directly – its true focus is on reducing the budget deficit so that the Reserve Bank won’t have to raise interest rates as much to control inflation.

But the big fall in this year’s deficit – made possible by the greater tax revenue from higher export prices – isn’t expected to stop the deficit rising the following year.

And although the budget does include measures that will cut costs for some families – for childcare and prescriptions – these are election promises, not newly announced moves.

The budget’s biggest bad news is that the cost-of-living squeeze is now expected to continue for another two years, with price rises continuing to outpace wage rises. And even when the squeeze stops, real (inflation-adjusted) wages will be a lot lower than they were before the pandemic.

Strangely, the budget’s best news is that the economy’s rate of growth is forecast to slow to just 1.5 per cent in the year to June 2024.

What sounds bad is good when you remember the growing likelihood of a global recession. While most rich economies will go backwards, we should only slow down. Our rate of unemployment is predicted to rise just a bit from its near 50-year low.

World recessions mean we earn less from our exports. They don’t necessarily drag us into recession, as our earlier run of almost 30 years without a recession demonstrates.

Still, a forecast is only a forecast, not a guarantee. The main factor determining if we too end up with negative growth will be whether, in its efforts slow the rate of inflation, the Reserve Bank accidentally raises interest rates more than needed.

This is the BNPL budget – buy now, pay later. Labor bought an easy return to government by promising lots more spending on better government services, while also promising not to increase any taxes – apart from on wicked multinationals – and not to interfere with the already legislated stage three income tax cuts, due in July 2024.

This budget is Labor’s payment for the election it bought. But, as with BNPL schemes, payment comes in four instalments. This is just the first of the four budgets the government expects to deliver before the next election.

Chalmers says it’s “a beginning of the long task of budget repair, not the final destination”.

True. Another way to put it is that this is only the start of his Dance of the Four Veils. In the end, all will be revealed. But right now, we’ve been shown little.

Chalmers keeps saying he wants to “start a conversation” about what services we want government to provide, and how we should pay for them.

A few weeks ago, he got the conversation going by entertaining whether, in the light of all that’s transpired, the stage three tax cuts are still appropriate.

But his boss Anthony Albanese quickly closed the conversation down. No decision had been made to change the cuts, he said firmly.

Since the cuts aren’t due for 20 months, there’s no need for any decision to be announced in this budget, or in next May’s budget. Indeed, any decision could be held off until the third veil is removed in May 2024.

Albanese is waiting and manoeuvring until time and circumstance have convinced us it would be better for the promise to be broken. He’d like people marching the streets with banners demanding the tax cut be dropped.

Those hugely expensive and unfair tax cuts would be so counterproductive to all the problems Chalmers is grappling with, I don’t doubt that at a propitious time, a decision to reduce them will be unveiled.

This will set the stage for the final unveiling of the government’s plan to increase taxes after the next election.

Why am I so sure? Because everything the government is doing and saying points to the need for taxes to go up, not down.

Finance Minister Katy Gallagher has slashed away at the Morrison government’s spending on “rorts and waste”, to make room for Labor’s spending promises – not all of which escape a similar label.

But she has also exposed the way her predecessors were holding back spending on aged care, health, education and much else. Add the National Disability Insurance Scheme, defence, and the interest bill, and you see that strong spending growth in coming years will be unavoidable.

Except for the government’s reticence on tax issues, Chalmers is justified in his repeated claim that this is a “responsible” budget. His more debatable claim is that the budget’s first priority was to provide cost-of-living relief.

That claim came with a heavy qualification: that relief had to be “responsible, not reckless … without adding to inflation”. Yes, the adults are back in charge of the budget.

But the government reticence on tax issues is a big exception to its record on responsible budgeting. The huge increases in gas and electricity prices – mostly collateral damage from Russia’s war on Ukraine – that will do most to continue the cost-of-living squeeze on families this year and next are counterbalanced by the massively increased profits of our exporters of fossil fuel.

Labor’s irresponsible election promise to bind its hands on tax changes has stopped it giving hard-pressed households the consolation of seeing most of those windfall profits taxed, and so returned to other taxpayers for use on more deserving causes.

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Monday, September 26, 2022

Monetary policy is no longer fit for purpose

It’s an outstanding feature of the modern economy: the multitude of people who could do a far better job of running interest rates than the fool they’ve got doing it at the moment. Welcome to the inquiry into the performance of the Reserve Bank.

One small problem. About half governor Dr Philip Lowe’s critics complain he was too slow putting rates down, while the other half say he was too slow putting them up. Since interest rates are a cost to borrowers but income to savers, it’s hardly surprising that, whichever way the Reserve jumps, many will be complaining.

To be clear, it’s always a good idea to review regularly the performance of an institution with as much power over our lives as the central bank.

But equally, the inquiry needs to focus on the right question. Some critics just want someone to agree with them that the Reserve could have done a better job in recent years. Others – particularly academics specialising in monetary economics – want to argue about the mechanics.

Should we change the monetary target? Since the Reserve’s procedures aren’t identical to the US Federal Reserve’s, doesn’t that mean we’re doing it wrong? Why stack the Reserve’s board with business worthies when it would make much better decisions if you stacked it with academic experts like me and my mates?

Leaving aside those who just care about how much interest they’re paying or receiving, most of those who were pushing for the inquiry have a vested interest in monetary policy continuing to be the dominant instrument used in the year-to-year management of demand. They need monetary policy to stay dominant because their living depends on it.

But monetary policy’s role in the “policy mix” is the most important question. Just as much of the pomp and pageantry we’ve been watching isn’t as ancient as many monarchists imagine, monetary policy has been the main instrument used to manage demand only since the late 1970s.

Before then, fiscal (budgetary) policy was dominant, with monetary policy an afterthought, and the central bank a vassal of Treasury. The switch made sense then, but does it still?

And even then, we got off on the wrong foot, starting by trying to control the supply of money, which didn’t work. We didn’t switch the focus to controlling interest rates until the early ’80s. The inflation target came in the mid-90s, and it wasn’t until 1997 that the Reserve’s independence from the elected government was formalised.

It would be nice to imagine we’re gradually closing in on the one right way to manage the economy, but this would be a delusion. History tells us we keep changing the way we do it to better fit the particular problems of the era. Indeed, it wasn’t until the late 1940s that everyone agreed there was a macroeconomy that needed managing.

The two main “arms” of macro management (we abandoned the third arm, exchange rate policy, in 1983 when maintaining a fixed exchange rate became impossible) have different strengths and weakness.

The great advantage of monetary policy is that the econocrats who run it can ignore the electoral cycle. It can also be adjusted quickly and easily. But after acknowledging that, it’s otherwise inferior to fiscal policy. It can’t be targeted at particular regions or industries, and it takes longer to do what you need it to – with the notable exception of house prices.

Our present problem of sudden, high inflation – caused by disruptions to the supply (production) side of the economy being exacerbated by an overstimulated demand (spending) side – well demonstrates the bluntness, crudeness and unfairness of monetary policy.

This raises two questions. Did we need to use both arms of policy to respond to the pandemic? And how much of our present excess demand can be attributed to monetary policy?

The econocrats defend what, with hindsight, was clearly too much stimulus, by saying they didn’t know how much economic disruption the pandemic would cause, the medicos initially led them to believe it could be much worse than it turned out to be and, anyway, it’s better to err on the side of doing too much than too little.

But none of that says we had to overdo it on both barrels. With the official interest rate already down to 0.75 per cent before the virus arrived, it was clear the Reserve was almost out of ammo. I imagined it would have little more to contribute, leaving fiscal policy to do all the heavy lifting. As it did.

But no, the Reserve rode to the rescue as though it was the only knight that could find a horse. It slashed rates to near zero, offered cheap loans to the banks and, before long, joined the bigger central banks in buying government bonds with created money, to lower longer-term interest rates.

At the time, I wondered whether this was just institutional turf protection. It was the Reserve’s job to be the chief demand manager, and it wasn’t going to sit out the biggest crisis in ages just because it had run out of ammo. We’ll find something we can make into bullets.

Looking back, I suspect the Reserve’s determination not to be left out of the party has added greatly to our new problem and to the pain it’s inflicting on us to fix the problem. When you boil it down, one of the main “channels” through which monetary policy influences demand is by interfering in the cost of housing.

The Reserve is right to say interest rates aren’t the primary cause of high house prices, but because monetary policy is such a one-trick pony, it can only ignore all the pain it inflicts by causing prices to soar when it cuts rates and fall when it raises them.

Between the two arms, they’ve revved up the housing industry, only now to be hitting the brakes. They’ve caused surprisingly few extra homes to be built, but pushed up the price of new homes by 20 per cent, adding 1.8 percentage points to the 6.1 per cent inflation rate.

According to Professor Simon Wren-Lewis, of Oxford, the old consensus among academics that monetary policy should take the lead in demand management, has been replaced by one where interest rates are the favoured instrument to deal with inflation – as now – but fiscal policy should be the main weapon used to fight recessions. Or lockdowns.

Point is, had we followed that rule during the pandemic, we’d now have a much smaller inflation problem. Something the inquiry should ponder. And whether resorting to “unconventional measures” was ever a smart idea.

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Monday, September 19, 2022

Don't worry about inflation, the punters will be made to pay for it

Our sudden, shocking encounter with high inflation has brought to light a disturbing truth: we now have a dysfunctional economy, in which big business has gained too much power over the prices it can charge, while the nation’s households have lost what power they had to protecting their incomes from inflation.

It has also revealed the limitations and crudity of the main instrument we’ve used to manage the macro economy for the past 40 years: monetary policy – the manipulation of interest rates by the central bank.

We’ve been reminded that monetary policy can’t fix problems on the supply (production) side of the economy. Nor can it fix problems arising from the underlying structure of how the economy works.

All it can do is use interest rates to speed up or slow down the demand (spending) side of the economy. And even there, it has little direct effect on the spending of governments or on the investment spending of businesses.

Its control over interest rates gives it direct influence only on the spending of households. And, for the most part, that means spending that has to be done on borrowed money: buying a home. But also, renting a home some landlord has borrowed to buy.

Get it? The Reserve Bank of Australia’s governor’s power to manipulate interest rates largely boils down to influencing how much households spend on their biggest single item of spending: housing. Because no one wants to be homeless, using interest rates to increase the cost of housing leaves people with less to spend on everything else.

This means the governor has little direct influence over big business’s ability to take advantage of strong demand to widen its profit margins. He must get at businesses indirectly, via his power to reduce their customers’ ability to keep buying their products.

Get it? Households are the meat in the sandwich between the Reserve and big business (with small business using the cover of big business’s big price hikes to sneak up their own profit margins).

Join the dots, and you realise the Reserve’s plan to get inflation down quickly involves allowing a transfer of many billions from the pockets of households to the profits of big business.

On one hand, big business has been allowed to raise its prices by more than needed to cover the jump in its costs arising from the supply disruptions of the pandemic and the Ukraine war. On the other, the loss of union bargaining power means big business has had little trouble ensuring its wage bill rises at a much lower rate than retail prices have.

So, it’s households that are picking up the tab for the Reserve’s solution to the inflation problem. They’ll pay for it with higher mortgage interest rates and rents, and a fall in the value of their homes, but mainly by having their wages rise by a lot less than the rise in their cost of living.

The RBA’s unspoken game plan is to squeeze households until demand for goods and services has weakened to the point where big business decides that raising its prices to increase its profits would cost it so many sales that it would be left worse off.

It may even come to pass that households have been squeezed so badly big businesses’ sales start falling, and some of them decide that cutting their price to win back sales would leave them better off.

In economists’ notation, maximising profits – or minimising losses – is all about finding the best combination of “p” (price) and “q” (quantity demanded).

You don’t believe big businesses ever cut their prices? It’s common for them to “discount” their prices in ways that disguise their retreat, using special offers, holding sales, and otherwise allowing a gap between their advertised price and the price many customers actually pay.

But why would that nice mother’s boy Dr Philip Lowe, whose statutory duty is to ensure that monetary policy is directed to “the greatest advantage of the people of Australia”, impose so much pain on so many ordinary people, who played no part in causing the problem he’s grappling with?

Because, as all central bankers do, he sees keeping inflation low as his central responsibility. And he doesn’t see any other way to stop prices rising so rapidly. It’s a case study in just what a crude, inadequate and blunt instrument monetary policy is.

Lowe justifies his measures to reduce inflation quickly by saying this will avoid a recession. But let’s not kid ourselves. This massive transfer of income from households to business profits will deal a great blow to the economy.

After going nowhere much for almost a decade, real household disposable income is now expected to fall for two years in a row. And who knows if there’ll be a third.

Economists have made much of the extra saving households did during the pandemic. But during Lowe’s appearance before the parliamentary economics committee on Friday, it was revealed that about 80 per cent of that extra $270 billion in saving was done by the 40 per cent of households with the highest incomes. So, how much of it ends up being spent is open to question.

The likelihood that our measures to weaken household spending will lead to a recession must be very high.

Until Lowe’s remarks before the committee on Friday, his commentary on the causes and cure of inflation seemed terribly one-sided. The key to reducing inflation was ensuring wages didn’t rise by as much as prices had, so that rising inflation expectations wouldn’t lead to a wage-price spiral.

He warned that the higher wages rose, the higher he’d have to raise interest rates. He lectured the unions, saying they needed to be “flexible” in their wage demands. You could see this as giving an official blessing to businesses resisting union pressure and granting pay rises far lower than prices had risen.

Lowe could just as easily have lectured business to be “flexible” in passing on all the higher cost of their imported inputs, when these were expected to be temporary – but he didn’t. He’s always quoting what business people are saying to him, but never what union leaders say – perhaps because he never talks to them.

But on Friday he evened up the record. “It is also important to note that, to date, the stronger growth in wages has not been a major factor driving inflation higher,” he said. “Businesses, too, have a role in avoiding these damaging outcomes, by not using the higher inflation as cover for an increase in profit margins.”

That’s his first-ever admission that, when conditions allow, business has the market power to raise its prices by more than just its rising costs. Problem is, monetary policy’s only solution to this structural weakness – caused by inadequate competitive pressure – is to keep demand perpetually weak.

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Monday, August 22, 2022

Housing own goal worsens our inflation problem

A key part of the economic response to the pandemic was to rev up the housing industry. It’s boomed and now it’s busting. What’s been achieved? Mainly, a big, self-inflicted addition to our inflation problem.

That, and a lot of recent first-home buyers now getting their fingers burnt. Well done, guys.

It’s not a crime to be wise after the event. Indeed, it’s a crime not to be. As we all know, you learn more from your mistakes than your successes.

We have much to learn from our mishandling of the economic aspects of the pandemic. Because we had no experience of pandemics, our mistake was to treat the lockdowns as though they were just another recession. Turned out they’re very different.

Because downturns in home building and house prices often lead the economy into recession, then a recovery in home building leads it out, the managers of the macroeconomy assumed it would be the same this time.

The federal government offered HomeBuilder grants to people ordering new homes or major alterations. The state governments offered stamp duty concessions to first-home buyers, provided they were buying new homes.

But the doozy was the Reserve Bank’s decisions to cut the official interest rate from 0.75 per cent to 0.1 per cent, and then cut the base rate for 3- and 5-year fixed-rate mortgages.

By the end of last year, according to the Bureau of Statistics, the median house price in Sydney and Melbourne had jumped by more than 40 per cent. In the following quarter, it fell by 7 per cent in Sydney and 10 per cent in Melbourne. By all accounts, it has a lot further to fall.

Turning to building activity, we’ve seen a surge in the number of new private houses commenced per quarter, which jumped by two-thirds over the nine months to June 2021. Then it crashed over the following nine months, to be up only 14 per cent on where it was before the pandemic.

It’s no surprise commencements peaked in June 2021. Applications for the HomeBuilder grant closed 14 days into the quarter.

But to commence building a house is not necessarily to complete it a few months later. The real value of work done on new private houses per quarter rose by just 15 per cent over the nine months to June 2021. Nine months later, it was up 12 per cent on where it was before the pandemic.

For the most part, the home building industry kept working through the two big lockdowns. It seems that, between them, the nation’s macro managers took an industry that was plugging along well enough, revved it up enormously, but didn’t get it building all that many more houses, nor employing many more workers.

Perhaps it soon hit supply constraints – shortages of building materials and suitable labour. I don’t know if the industry was lobbying governments privately for special assistance, or whether it didn’t have to. Maybe pollies, federal and state, just instinctively rushed to its aid.

But I wonder if the builders didn’t particularly want to get much bigger. There are few industries more cyclical than home building. Builders are used to building activity going up and down and prices doing the same.

When demand is weak, they try to keep their team of workers and subbies together by cutting their prices, maybe even to below cost. Then, when demand is strong, they make up for it by charging all the market will bear.

It’s the height of neoclassical naivety to think it never crosses the mind of a “firm” existing outside the pages of a textbook that manipulating supply might be a profitable idea.

So maybe the builders found the thought of increasing their prices more attractive than the thought of building a bigger business to accommodate a temporary, policy-caused surge in demand.

They may have taken a lesson from those property developers with large holdings of undeveloped land on the fringes of big cities. Dr Cameron Murray, a research fellow in the Henry Halloran Trust at Sydney University, has demonstrated that the private land-bankers limit the regular release of land for development in a way that ensures the market’s never flooded and prices just keep rising.

So, back to our inflation problem. Whenever people say the recent huge surge in prices is caused largely by overseas disruptions to supply, which can’t be influenced by anything we do, and will eventually go away, the econocrats always reply that some price rises are the consequence of strong domestic demand.

That’s true. As I wrote last week, it seems clear many of our businesses – big and small – have used the cover of the big rises in the cost of their imported inputs to add a bit for luck as they pass them on to consumers.

But I saved for today the great sore thumb of excess demand adding to the price surge: the price of building a new home (excluding the cost of the land) or major renovations. This accounted for almost a third of the rise in the consumer price index in the June quarter, and jumped by more than 20 per cent over the year to June.

The price of newly built homes has a huge weight of almost 9 per cent in the CPI’s basket of goods and services, making it the highest-weighted single item in the basket. This implies that new house costs have added almost 2 percentage points of the total rise of 6.1 per cent.

When the econocrats worry about the domestic contribution to the price surge, they never admit how much of that problem has been caused by their own mishandling of the pandemic.

Indeed, when people argued that the main thing further cutting interest rates would achieve would be to increase house prices, the Reserve was unrepentant, arguing that raising house prices and demand for housing was one of the main “channels” through which lower rates lead to increased demand.

But the crazy thing is, this strange way of using the cost of a new dwelling to measure the cost of housing for home-buyers – which, I seem to recall, was introduced in 1998 after pressure from the Reserve – exaggerates the true cost for people with mortgages, especially at times like these.

Few people ever buy a new dwelling and, even if they do, rarely pay for it in cash rather borrowing the cost. This is one reason the bureau doesn’t regard the CPI as a good measure of the cost of living, but does publish separate living-cost indexes for certain types of households.

Ben Phillips, of the Centre for Economic Policy Research at the Australian National University, has used the bureau’s living-cost indexes to calculate that about 80 per cent of households had a living cost increase below the CPI’s rise of 6.1 per cent. The median (typical) increase over the past year was 4.7 per cent.

What trouble the econocrats get us into when they use housing as a macro managers’ plaything.

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