Treasury explains why we shouldn't worry about the economy

There’s a lesson for Scott Morrison in new Treasury secretary Dr Steven Kennedy’s first public speech this week: put the right person at the top of Treasury and they’ll defend the government’s position far more eloquently and persuasively than any politician could. The econocrat’s greater credibility demands they be taken seriously.

I fear that time will show it's been a costly mistake by the government not to respond to Reserve Bank governor Dr Philip Lowe’s unceasing requests for budgetary stimulus to supplement the diminishing effectiveness of interest rate cuts. Costly in terms of lost jobs – perhaps even including the Prime Minister’s.

But that Kennedy’s opening statement at Treasury’s appearance before Senate Estimates is a robust defence of official policy should surprise no one (except politicians, who are prone to paranoia). In my experience, senior Treasury officers never gainsay the government of the day, in public or private. If it’s an independent view you’re after, try the Reserve.

However, since this is the most ably argued exposition of the government’s case for sitting tight, it deserves to be reported in detail.

Kennedy is clearly worried about the threat to us from events in the rest of the world, but is
"cautiously optimistic" that the domestic economy will pick up. According to the government’s long-established "frameworks" for the respective roles of the two policy arms used to manage the macro economy – monetary policy (interest rates) and fiscal policy (the budget) – the heavy lifting is done by monetary policy, with fiscal policy being used only during a crisis. As yet, there’s no crisis.

Over the past year, Kennedy says, global growth has slowed. As a result, the International Monetary Fund and the Organisation for Economic Co-operation and Development now expect world growth this calendar year to be the slowest since the global financial crisis in 2008. Even so, they expect growth next year to improve to about 3 to 3.4 per cent – "which is still reasonable".

Chief among the factors involved are the ongoing and still evolving "trade tensions" between the United States and China. "There is no doubt that trade tensions are having real effects on the global economy, which you see in trade data from the US and China," he says.

Combined with other problems – Brexit, Hong Kong, and concerns about the financial stability of some countries – trade tensions are leading to an increased level of uncertainty around the outlook for the world economy.

Many central banks have responded to slowing global growth by supporting their economies. And South Korea and Thailand have also provided more supportive fiscal policy.

Turning to the domestic economy, it slowed in the second half of last year, then grew more strongly in the first half of this year. This amounted to growth of just 1.4 per cent over the year to June.

Household consumption, the largest part of the economy, grew by 1.4 per cent, held down mainly by weak growth in wages. Linked to this is a fall in home building over the past three quarters, which is likely to continue in the present financial year.

Moving to business investment spending, mining investment fell by almost 12 per cent over the year to June, and non-mining investment was weaker than expected.

But, Kennedy argues, these problems are temporary and "there are reasons to be optimistic about the outlook". Recent figures have shown early signs of recovery in the market for established housing. Overall, capital city house prices have risen for the past three months. Auction clearance rates have picked up and more homes are changing hands.

Consumer spending will be supported by the government’s tax cuts and the Reserve’s three cuts in interest rates.

The substantial investment in mining capacity of past years is boosting exports, and mining investment spending is expected to grow this year rather than contract, as it had been since 2012.

Despite modest growth in the economy, employment has continued to be strong, increasing by more than 300,000 over the past year. The rate of unemployment has been "broadly flat" rather than falling because near-record rates of new people are joining the labour force and getting jobs.

The rate of improvement in the productivity of labour – output per hour worked – has averaged 1.5 per cent a year over the past 30 years, but slowed to just 0.7 per cent a year over the past five. This isn’t as bad as it looks because it’s exactly what arithmetic would lead you to expect when employment is growing faster than output. And even 0.7 per cent is higher than the G7 economies can manage.

Now to the question of whether the government should be applying fiscal stimulus to guard against a recession.

Kennedy says that, in an open economy such as ours, having a medium-term "framework" (set of rules) for the way fiscal policy should be conducted, in concert with a medium-term framework for the way monetary policy should be conducted, "has long been held to be the most effective way to manage the economy through cycles".

Under this view, fiscal policy’s medium-term objective is to deliver sustainable patterns of taxation and government spending [and thus a sustainable level of public debt].  A further objective is usually to minimise the need for taxation, as is the case in Australia.

This approach reflects an assessment that apparent short-term economic weakness or, alternatively, unsustainably strong growth, is best responded to by monetary policy, not fiscal policy.

Within this framework, however, the budget’s in-built "automatic stabilisers" will assist monetary policy in stabilising the economy. For instance, revenue will weaken, and payments will strengthen, when an economy experiences weakness.

The other exception to the rule that fiscal policy should be focused exclusively on achieving sustainable public debt is that there’s a case for "temporary [note that word] fiscal actions" in periods of crisis.

But "the circumstances or crisis that would warrant temporary fiscal responses are uncommon".

So, sorry, Phil. Application denied.

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Barring another financial crisis, it will be a long wait for QE

It’s amazing so many people are so sure they can see where the Reserve Bank is headed. Once interest rates are down to zero it will be on to QE - “quantitative easing” – and negative interest rates, they assure us. Don’t you believe it.

What’s surprising is how heavily the self-proclaimed experts are relying on their vivid imaginations. Or maybe lack of imagination, falling back on the lazy market dealer’s assumption that we should do – and will do – whatever the Americans have done.

What few in the financial markets and financial media are doing is their due diligence: carefully examining what the Reserve – particularly its governor, Dr Philip Lowe – has actually said about its attitude towards “unconventional monetary policy tools”.

Lowe had a lot to say when he appeared before the House economics committee in August. And in the Reserve’s written response to the committee’s questions. As well, Lowe had more to say when delivering a report on the topic by a Bank for International Settlements committee (BIS), which he chaired.

People assume the Reserve is hot to trot. It ain’t. It began the written response by saying “while at this point it is unlikely that the Reserve Bank will need to employ unconventional monetary measures, the [board] considered it prudent to understand the issues involved and has studied the experience of other countries”.

Prudence is the word. Since these are times when the unprecedented has become commonplace, Lowe is resolved to “never say never”. But don’t mistake this for enthusiasm. Read what he says -more in his remarks on his own behalf than as chair of the BIS committee – and you see how reluctant he is to start down the unconventional road.

He keeps repeating that the effectiveness of the various unconventional measures “depends upon the specific economic and financial conditions facing each economy at the time, as well as the structure of its financial system”.

That’s his way of saying, just because the Yanks did it, doesn’t mean we will.

His reference to the particular structure of a country’s financial system is especially relevant to the unconventional tool so many people assume is next: “purchasing government securities, so as to lower long-term risk-free interest rates”.

It’s a lot easier to believe this would stimulate private sector borrowing and spending in financial systems where home loans and business borrowing are geared to “the long end” – such as America’s – than in systems like ours, where lending for housing and small business is based on the short term and variable end of the interest-rate yield curve.

And Lowe’s reference to financial conditions at the time is also relevant: long-term interest rates are already at unprecedented lows. What would be gained by making them even lower?

If there’s one thing we ought to have figured out by now it’s that, whatever ails our economy at present, it ain’t that interest rates are too high.

People in the financial markets can fail to see this because, in all the trading of currencies and securities they do (many, many times more than would be necessary just to provide firms in the real economy with “deep” markets), so many of them make their living betting on the central bank’s next move.

When you’ve fallen into the habit of seeing the Reserve’s main role as holding regular race meetings, you see the conventional race days continuing until the official interest rate hits zero, obliging it to move to unconventional race days.

Trouble is, the Reserve thinks monetary policy is about the effect it has on the real economy of households and businesses, not about keeping money-market dealers in the luxury to which they’ve become accustomed.

For instance, it’s not at all clear that it will keep cutting until it hits zero. In its written response, the Reserve says that reducing the long-term bond rate “would involve reducing the cash rate to a very low level [my emphasis] and possibly purchasing government securities”.

Why get off at Redfern? Because there’s little point in cutting the official rate beyond the point where the banks are able to pass it on to their customers in the real economy.

Similarly, why would the Reserve engineer negative interest rates if the banks couldn’t get away with passing them on to their customers?

Lowe says the most clearly successful use of unconventional tools – buying private-sector securities - was at the height of the financial crisis when “the financial sector stalled and stopped doing its job, hamstrung by losses and drained of liquidity”.

However, security-buying policies aimed primarily at providing monetary stimulus were less obviously successful. So, should another financial crisis cause particular markets to freeze then, yes, sure, the Reserve would be in there taking whatever unconventional measures were needed to get them going again.

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How strange could money get if the worst came to the worse?

With our official interest rate heading ever closer to zero, there’s much talk that the Reserve Bank may be forced to join other central banks in resorting to “unconventional monetary policy,” including QE – “quantitative easing”. But how likely is this? What might it involve? Are there alternatives? And would it be good or bad?

These questions were debated by Dr Stephen Kirchner, of the United States Studies Centre at Sydney University, Dr Stephen Grenville, a former deputy governor of the Reserve now at the Lowy Institute, and Lyn Cobley, boss of Westpac’s institutional bank, at a meeting of the Australian Business Economists in Sydney this week.

But let’s start with what the Reserve’s governor, Dr Philip Lowe, said on the subject to the House’s economics committee earlier this month.

He said it was possible the official interest rate would end up at zero. Here’s the key quote: “I think it’s unlikely, but it is possible. We are prepared to do unconventional things if the circumstances warranted it.”

The Reserve had been doing a lot of thinking about unconventional policies, so as to be ready if they proved necessary, not because it thought them likely to be needed.

“I hope we can avoid that,” he said. Which I take to mean that, should they prove needed, the economy’s prospects would be much worse than they are now. But also that the Reserve doesn’t fancy having to use unconventional methods.

Conventional monetary policy involves the central bank using its “open market operations” (selling or buying Commonwealth bonds from the banks) to push its official interest rate, and hence the banks’ short-term and variable interest rates, up or down so as to discourage or encourage borrowing and spending (“demand”) in the economy.

Lowe’s list of unconventional measures includes the “negative” interest rates applying in Switzerland, the euro area and Japan (where lenders pay the borrowers tiny interest rates; don’t hold your breath waiting for this one), the central bank lending funds to banks at below-market rates provided they lend them on to businesses, the central bank buying corporate bonds or mortgage-backed securities, or intervening in the foreign exchange market to push the value of its currency down.

But the measure Lowe seemed least uncomfortable with is the central bank buying long-term government securities to try to lower risk-free long-term interest rates. This is similar to conventional policy, just at the long end rather than the short end.

Lowe also said that, if it became necessary to start buying long-term securities, you wouldn’t need to have cut the official interest rate to zero before you started. He implied he might go no lower than 0.5 per cent.

Why stop there? Because by then the banks’ deposit rates would be too low to be cut any further, meaning they couldn’t pass the cut on to their home-loan and business borrowers.

However, he admitted, if things got so bad internationally that all the other central banks had cut their official rates to zero, we might be obliged to follow suit. Another possibility would be if our economic growth slowed even further – say, into the 1 per cent range – though in that case a response would be needed from fiscal policy (the budget) as well as monetary policy.

Turning to this week’s debate, Westpac’s Cobley made it clear the banks would have trouble coping with most of the unconventional measures. Even cutting the official rate any further would hit the banks’ profits (sounds of weeping and breast-beating by the bank customers present).

Kirchner, who is among the minority of economists who believe fiscal policy is ineffective in managing demand, saw no problem with using unconventional measures, which could easily have the same effect as cutting the official rate by a further 2.5 percentage points.

He said the consensus of academic studies was that unconventional measures in the US had been quite effective. Grenville agrees with him that, for the central bank to switch from buying short-term securities to buying long-term securities in no way constitutes “printing money” (even metaphorically).

Grenville disagreed with his claim that unconventional measures don’t promote inequality by helping the rich get richer, however. They lead to higher prices in the markets for shares and property, which help expand the economy through a “wealth effect” – working best for the wealthy.

Except where unconventional measures were used to rescue financial markets that had frozen at the height of the financial crisis, Grenville was unconvinced they achieved much. The academic studies made too little distinction between different episodes.

So he opposes taking interest rates lower and moving on to unconventional measures. Rather, the Reserve should tell the government monetary policy had gone as far as it reasonably could – was already “pedal to the metal” – so now it was over to fiscal policy.

Unconventional measures (I think “quantitative easing” is misleading) would probably achieve lower long-term interest rates, inflate asset prices (particularly shares), encourage financial risk-taking and lower the exchange rate, Grenville said.

None of those things seemed particularly desirable, he said. Lower long-term interest rates wouldn’t help much because, unlike in America, Australian households and businesses borrow at the short end. We’ve had plenty of asset-price inflation already.

A lower dollar helps our exporters, but it’s a “beggar-thy-neighbour” policy (inviting others to do the same to us) and, in any case, the dollar is already low enough to make any viable exporter profitable.

When unconventional measures are discussed, some people think of “helicopter money” – governments distributing cash to ordinary punters, from a metaphorical helicopter. But central bankers insist such a measure is not monetary policy and would have to come from the government as part of fiscal policy.

If the government covered the cost of the cash by borrowing from the public in the usual way, such a stimulus measure would be quite conventional – a la Kevin Rudd’s 2008 “cash splash” into people’s bank accounts.

If the government simply ordered the Reserve to credit people’s bank accounts, that would be “printing money” and highly unconventional. Again, don’t hold your breath.

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Are low interest rates bad? It depends on your perspective

Although media coverage invariably assumes that low interest rates are good news, they’re now so low there’s a backlash, with people pointing to the disadvantages of low rates and getting quite worried.

The fightback is coming at the usual level of complaints from the retired, but also from more sophisticated observers, such as Andrew Ticehurst, of the Nomura banking group, and Dr Stephen Grenville, a former deputy governor of the Reserve Bank.

It’s understandable that the retired and other savers object to the Reserve Bank’s decisions to cut interest rates and are particularly exercised now rates are so close to zero. Doesn’t the Reserve understand we live on our interest income? Of course it does. So why does it persist?

Interest rates are the price borrowers pay lenders (and, ultimately, savers) for the use of their money for a period. Clearly, cutting rates benefits borrowers at the expense of savers. Central banks cut rates to encourage borrowing and spending because they know the expansionary effect on borrowers greatly exceeds the contractionary effect on savers.

They’ll never be dissuaded from this approach. It’s true interest rates are a “blunt instrument”, but they’re pretty much the only instrument central bankers have.

The retired are on much stronger ground when they insist the government continually updates the “deeming rates” it uses to assess the effect of people’s savings on the amount of their part-pension. It’s surprising the grey lobby has taken so long to wake up to this.

The more sophisticated criticism is that, though market economies thrive on risk-taking (and this is one of the mechanisms by which lower rates are expected to stimulate demand), unduly low rates encourage excessive risk-taking.

Businesses are encouraged to become dangerously highly “geared” or “leveraged” (too dependent on borrowed capital rather than share capital) and firms invest in projects that are high-risk or are profitable only if the cost of borrowing is unrealistically low.

In both cases, the seeds of the next bust are being sown. When rates go back up, firms and projects will fall over and there’ll be hell to pay. Very low rates also allow the survival of “zombie” firms – those that have failed and should have died, but are still living – which tie up resources that could be used more efficiently elsewhere.

Running “ultra-loose monetary policy” at a time when demand is weak can do more to cause dangerous bubbles in share, property and other asset markets than to stimulate markets for goods and services.

There’s merit in these arguments – in normal times. But this brings us to the key question of our times: are our present troubles cyclical or structural? Is it just taking frustratingly long for the economy to return to the old normal, healthy rate of growth, or have so many major (but, as yet, not fully understood) changes occurred in the structure of the economy that a “new normal” has arrived, requiring us to get used to a much lower rate of growth, complete with permanently lower inflation and interest rates?

Treasury is sticking firmly to the view that we’ll soon return to the old normal (thus adding weight to the critics’ worries about the bad seeds being sown by protracted low interest rates) and so is the Reserve – except that governor Philip Lowe’s recent exposition of the reasons for persistent low inflation had a bob each way, nominating cyclical (spare capacity) and structural (effects of digitisation and globalisation) factors.

Remember, interest rates come in two parts: the borrower’s compensation to the lender for the loss of their money’s purchasing power while it’s in the borrower’s hands (the expected inflation rate) plus the borrower’s payment to the lender for the use of their money during the loan (the “real” interest rate).

For as long as inflation stays low, nominal interest rates will stay low – without any real loss to savers, even though their susceptibility to “money illusion” (forgetting to allow for inflation) means many don’t realise it.

And here’s something many people haven’t realised: globally, real interest rates have been falling since the 1970s and are still falling. Harvard’s Lawrence Summers finds in a recent paper that real rates have declined by at least 3 percentage points over the past generation.

Put the two parts together and interest rates – both nominal and real – look like staying low for a long time, whether we like it or not. This says many formerly unprofitable investment projects are now profitable, and budget deficits and high public debt are now much less worrying.

The critics imply the Reserve has great freedom to keep the official interest rate high or low. Not really. It can’t defy economic gravity. It’s the Morrison government that could, at the margin, use its budget to reduce the pressure on the Reserve to cut rates further.

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Star pupil Philip Lowe gives tips on why inflation is so low

Reserve Bank governor Philip Lowe started his study of economics at high school in Wagga Wagga and finished it with a PhD from the Massachusetts Institute of Technology. Much thanks to his teacher, Mrs King, whose teaching style convinced him economics was interesting as well as important.

The great attraction of high school economics is its emphasis on linking theory to current events.

According to a speech he gave last week, when Lowe did the HSC in 1979, the standard exam question was: why does Australia have both high inflation and high unemployment ("stagflation") and what’s the government doing about it?

In those days there was much interest in the "misery index", which adds the inflation rate to the unemployment rate. We got to peaks well above 20 per cent. Today, however, it’s below 7 per cent.

As the Australian Bureau of Statistics advised this week, the consumer price index rose by just 1.6 per cent over the year to June. Which means it’s been below the Reserve’s inflation target of "between 2 and 3 per cent, on average, over the medium term" for almost five years.

So Lowe’s guess is that, these days, exam questions are likely to ask: why is inflation so low at the same time as unemployment is also low – and what’s the government doing about it?

Just to be of help, he told us how he’d answer the question – which is one of interest and importance to all of us, not just youngsters preparing for their finals.

He started by noting that very low inflation has become the norm in most economies. At present, three-quarters of advanced economies have an inflation rate below 2 per cent.

There’s no single answer, he says, but there are three factors that, together, help explain what’s happened.

First, the credibility of the monetary "frameworks" that central banks eventually adopted when, in the second half of the 1970s, they realised inflation was way too high and needed to be got under control.

It wasn’t until the early '90s that our Reserve Bank adopted its present target for inflation which, as Lowe says, helped cement low inflation “norms” in the economy. In econospeak, it provided an anchor for business and unions’ expectations about how much prices were likely to rise over the next year or two.

"Many people understand that if inflation were to pick up too much, the central bank would respond to make sure the pick-up was only temporary,” Lowe says.

It would do so by raising interest rates and so discouraging borrowing and spending, of course. Economists call this the "monetary policy reaction function".

(It’s one of the reasons for the old view among economists that attempts to use the budget to stimulate demand by cutting taxes or increasing government spending wouldn’t achieve much. The central bank, fearing the stimulus would push up inflation, would react by raising interest rates and so stymie it. In the new world of continuing weak demand and too-low inflation, however, central banks are most unlikely to react to budgetary stimulus in such a way, meaning the new view is that budgetary stimulus is very effective.)

Has inflation targeting worked? Well, annual inflation has averaged 2.4 per cent since the target was adopted, so it certainly seems to have.

The second part of Lowe’s explanation for very low inflation is that spare capacity to produce goods and services (including spare workers who are unemployed or under-employed) in many advanced economies means there’s little upward pressure on prices.

That certainly seems the case in Australia. Our unemployment rate could go a lot lower than its present 5.2 per cent without causing wages to take off – especially with our under-employment rate of 8.3 per cent.

Our labour market seems to be more flexible – and less inflation-prone - than it used to be.

The third part of his explanation is that changes in the structure of the economy caused by technology and globalisation seem to be keeping prices low.

For one thing, digitisation and globalisation seem to be lowering the cost of producing many goods. The entry of China and other emerging economies into the global trading system has added hundreds of millions of factory workers to the global market.

The prices of manufactured goods in the advanced economies have barely increased over the past couple of decades.

For another thing, globalisation and advances in technology are making markets more contestable and increasing competition. This is extending beyond manufacturing to almost every corner of the economy, including the services sector.

Historically, most services couldn’t be traded across national borders. But globalisation – driven mainly by advances in information and communication technology – means many services can now be delivered by somebody in another country.

Examples include preparation of architectural drawings, document design and publishing, and customer service roles (a nice name for call centres). As well, many tasks such as accounting and payroll have been automated.

The internet and its digital “platforms” have revolutionised services such as retail, media and entertainment, and transformed how we communicate, and search for information and compare prices.

"These changes are having a material effect on pricing, with services price inflation lower than it once was. Many firms know that if they don’t keep their prices down, another firm somewhere in the world might undercut them," Lowe says.

"And many workers are concerned that if the cost of employing them is too high, relative to their productivity [an important qualification], their employer might look overseas or consider automation."

More broadly, using the internet for better “price discovery” keeps the competitive pressure on firms.

The end result is a pervasive feeling of more competition. And more competition normally means lower prices.

What’s the government doing about low inflation and the deficient demand that is part of its cause?

Well, if you mean the elected government, the short answer is: not nearly enough. Especially when you remember how little scope the Reserve Bank has left to cut interest rates.

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Despite the photo-op, RBA knows we need fiscal stimulus

Never fear, Reserve Bank governor Dr Philip Lowe may have stumbled on the optics of agreeing to a photo-op with Treasurer Josh Frydenberg the other week, but the Reserve’s independence remains intact and our weak economy remains in need of budgetary stimulus.

Politicians have damaged our trust so badly that they like having respected econocrats appearing beside them to bolster their credibility. But central bank governors who wish to preserve the authority of their office don’t oblige, just as Lowe’s predecessor, Glenn Stevens, declined to be used as a prop by Kevin Rudd.

That’s the trouble, of course. There’s nothing wrong with treasurers and governors having private meetings – the more the better – but once the media are invited in the pollies will always be playing their own game, and it’s always one that puts their political standing ahead of the economy’s interests.

I suspect the message Frydenberg wanted to convey to viewers was that the economy was going fine and he had no intention of allowing fiscal stimulus to jeopardise the budget’s predicted and glorious return to surplus, which would make his name as a treasurer.

He and his Treasury officers had spent two hours explaining this to Lowe, and Lowe had accepted their arguments.

I very much doubt that’s what really happened. Nor do I except the media interpretation that, pressured by Frydenberg, Lowe went on to repudiate all he’d been saying about the economy’s weakness and why he’d needed to cut the official interest rate two months in a row.

Why then did Lowe say “I agree 100 per cent with you [Frydenberg] that the Australian economy is growing and the fundamentals are strong”?

Well, for a start, no one denies that the economy is still growing. And “the fundamentals” is such a vague concept it could be taken to mean lots of things. Presumably, Lowe doesn’t include wages among the fundamentals, because annual growth of 2.3 per cent is not what I’d call strong.

I think all he was trying to say was that he was confident we aren’t heading into recession.

But there’s a deeper point to understand: central bankers see it as an important part of their job to exude calm and confidence. No matter how worried they are, they take pride in never showing it.

They’re like a duck: moving serenely above the water, paddling furiously underneath. Lowe has spoken several times recently about the need to preserve stability and confidence.

So never hold your breath waiting for a Reserve governor, Treasury secretary or, let’s hope, treasurer  to be the first to warn that recession is possible. They’ll be the last to admit it.

Like Paul Keating on the day he tried to conceal his failure by bulldusting about “the recession we had to have”, they don’t use the R word until the figures make it impossible to deny.

And that is just as it should be. Why? Because – particularly when it’s negative, and when sentiment is wavering – what they say has too much influence over what the rest of us think and do. Too much risk of their prophesies becoming self-fulfilling.

That’s why, as a mere media commentator, it’s my job to be brutally frank, and theirs to be circumspect.

And that’s why it’s wrong to claim Lowe has suddenly changed his tune about the economy’s prospects. Those who think otherwise are like the people in the famous psych experiment who were so busy counting points in a basketball match they didn’t notice a gorilla run across the court.

In his announcement of the second rate cut – as in almost all his recent public utterances – Lowe insisted that “the central scenario for the Australian economy remains reasonable, with growth around trend expected”.

The significant change has been the Reserve’s revised judgement that the “non-accelerating-inflation rate of unemployment” has fallen from about 5 per cent to 4.5 per cent or lower. Lowe has used this as his justification for cutting interest rates.

“Today’s decision to lower the cash rate will help make further inroads into the spare capacity in the economy” and “will assist with faster progress in reducing unemployment . . .”, he said in the announcement.

It’s a lovely thought, but I fear the immediate challenge is not to get unemployment lower, but to stop it continuing to rise. And the latter risk fits better with Lowe’s repeated calls for more help from the budget – for it to be pointing in the same direction as monetary policy (interest rates), not the opposite direction, as at present.

Frydenberg’s photo-op made it clear his answer is no. Perhaps at their next two-hour meeting Lowe should explain to him how the budget’s “automatic stabilisers” work, and may well wash away his promised budget surplus.

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Poor Josh Frydenberg: on the wrong tram, heading for trouble

It’s not my policy to feel sorry for any politician – they’re all hugely ambitious volunteers – but I do feel sympathy for Treasurer Josh Frydenberg. He’s not the first treasurer to be strong on party dogma but light on economic understanding, but he’s among the first to be heading into stormy weather light on expert advice from a confident and competent Treasury.

There he was, thinking his first budget would be his last, primping up a pre-election budget that claimed to have fixed the economy and delivered on deficit and debt when that was all in the future and built on nothing more than years of wildly optimistic forecasts, combined with a massive tax bribe whose cost will keep multiplying for seven years.

Do you think that while cooking up the happy forecasts needed to justify his claims of Mission Accomplished and make his tax cuts seem affordable, Treasury warned him of the risks he was running, making himself and his government hostages to fortune?

I doubt it. They wouldn’t have been game to. The Coalition’s politicisation of Treasury, intended to kill its corporate sense of mission and replace it with people who’d proved their right-thinking and party loyalty as ministerial staffers, sent the message that the government wanted people who spoke only when spoken to and kept any contrary opinions to themselves.

In the process, however, most of the people with a deep understanding of macro-economic management have drifted away. People who understood the mysteries of the business cycle, with experience of recessions - and how excruciatingly painful they are for the government of the day.

These are people who know how much worse you make it for yourself – and for the economy voters depend on – by refusing to face the mess you’ve got yourself into, and who know how to help you change trams with as little loss of face as possible.

People game to tell you to stop digging. People who know that the longer you take to accept that the game has changed, the harder it will be to get the economy back on track – and, incidentally, to avoid getting the blame for completely stuffing it up.

People who’ll tell you to blame your about-face on changes coming from the rest of the world, but not to believe your own bulldust. People who’ll tell you to forget about party political doctrine – and the crowing of your opponents - and be completely pragmatic in doing whatever needs to be done to get you and the economy out of the poo.

Here’s what Frydenberg’s experts should be telling him, but probably aren’t – unless he speaks to Reserve Bank governor Dr Philip Lowe a lot more regularly than I imagine he does.

First, worrying about deficit and debt is something national governments can afford to do only when they’ve got an economy that’s growing strongly. The three successive quarters of pathetically weak growth we’ve experienced – complete with rising unemployment and underemployment - may prove to be just a blip, as the budget’s forecasts assume they will, but it’s much easier to believe they show the economy is fast running out of puff.

Recession is neither imminent nor inevitable in the next year or three, but with the economy in such a weakened state it is vulnerable to any adverse shock that happens along – whether of domestic or international in origin.

In such circumstances, it would be economically damaging and fiscally counterproductive (not to mention politically disastrous) to press on with fiscal consolidation rather give top priority to boosting economic activity and getting the economy back into strong-growth mode.

The problem is, the economy seems to be running out of puff because it’s caught in a vicious circle: private consumption and business investment can’t grow strongly because there’s no growth in real wages, but real wages will stay weak until stronger growth in consumption and investment gets them moving.

Policy has to break this cycle. But, as Lowe now warns in every speech he gives, monetary policy (lower interest rates) isn’t still powerful enough to break it unaided. Rates are too close to zero, households are too heavily indebted, and it’s already clear that the cost of borrowing can't be the reason business investment is a lot weaker than it should be.

That leaves the budget as the only other instrument available. The first stage of the tax cuts will help, but won’t be nearly enough. “Structural reform” is always a nice idea, but fixing a problem of deficient demand from the supply side would take far too long to be of practical help.

Over to you, Josh. If you’ve got the greatness in you, this could be your finest hour.

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How to multiply the bang from your budget buck

Years ago, I came to a strong conclusion: the politician who could resist the temptation to use the budget to prop up the economy when it’s falling in a heap and making voters hugely dissatisfied has yet to be born.

So let me make a fearless prediction: whatever they’re saying now, sooner or later Treasurer Josh Frydenberg and his boss Scott Morrison will use “fiscal policy” (aka the budget) to help counter the sharp slowdown in the economy that, if we’re not careful or our luck doesn’t hold, could lead to something much worse.

How can I be so sure? Because I’ve seen it happen so many times before. As I wrote in this column last week, since the late 1970s it’s been the international conventional wisdom among governments and their advisers that “monetary policy” (interest rates) should be the chief instrument used to stabilise the economy as it moves through the ups and downs of the business cycle, with fiscal policy focused instead on achieving “fiscal sustainability” – making sure the public debt doesn’t get too high.

Take Malcolm Fraser, for instance. He spent almost all his time as prime minister trying to eliminate the big budget deficit he inherited from the Whitlam government.

Until, that is, his advisers noticed indications of what became the recession of the early 1980s. In his last budget, he cut taxes and boosted government spending.

The Hawke government was totally committed to leaving it all to monetary policy, and stuck to that even when Treasurer John Kerin brought down the 1991 budget during the depths of the recession we didn’t have to have in the early 1990s.

Except that, by this time, Paul Keating was on the backbench, telling everyone who’d listen that you’d have to be crazy not to be using the budget to stimulate the economy.

In February 1992, soon after he’d deposed Bob Hawke, Keating unveiled his own big One Nation stimulus package – which by then was far too late.

It was Dr Ken Henry’s realisation at the time that politicians will always do something, even if they should have done it much sooner that, after the global financial crisis in 2008, saw him urging Kevin Rudd to “go early, go hard, go households”.

Combined with a cut in interest rates far bigger than would be possible today, that fiscal stimulus was so effective in keeping us out of the Great Recession that, today, the punters have forgotten there was ever any threat and the Coalition has convinced itself it was never needed in the first place.

Now, as we also saw last week, with interest rates so close to zero, fiscal policy is back in fashion internationally – though I’m not sure the carrier pigeon has yet made it as far as Canberra. So we’ve got time for a quick refresher on how fiscal stimulus works while we wait for the penny to drop in the Bush Capital.

There is a “circular flow of income” around the economy, caused by the simple truth that one person’s spending is another person’s income. This means that $1 spent by the government (or anyone else, for that matter) can flow around the economy several times.

This is what economists call the “multiplier” effect. Just how big the multiplier is for any spending will depend on the “leakages” from the flow that happen when someone decides to save some of their income rather than spend it all, or when they spend some of their income on imported goods or services (including overseas holidays).

(There are also “injections” to the flow from investment – someone uses or borrows savings to spend on a new house or office or equipment – and from exports of goods or services to foreigners.)

This means that the degree of stimulus the economy receives will differ according to the choices the government makes about the form its stimulus will take.

In a briefing note prepared by Dr Peter Davidson for the Australian Council of Social Service, he quotes research on the size of multipliers calculated by the Congressional Budget Office for the various measures contained in President Obama’s stimulus package in 2009, after the financial crisis.

Where the government spent directly on the purchase of goods and services, $1 of spending increased US gross domestic product by between 50¢ and $2.50. Where the spending was money given to state governments for the construction of infrastructure, the multiplier ranged between 0.45 and 2.2.

For spending on social security payments, the multiplier ranged between 0.45 and 2.1. For one-off payments to retirees, it was between 0.2 and 1. For grants to first-home buyers, between 0.2 and 0.7.

Turning from government spending to tax cuts, the budget office found than tax cuts for low to middle income-earners yielded a multiplier of between 0.3 and 1.5. For tax cuts for high income-earners, it was between 0.05 and 0.6. For additional company tax deductions, it was 0.4.

These big differences aren’t hard to explain. Multipliers are highest for direct government purchases or construction because there’d be no initial leakage into saving and little into imports.

The multipliers for tax cuts are lower because of initial leakage into saving and imports – not so much for low and middle income-earners, but hugely so for high income-earners.

Davidson’s conclusion is that a fiscal stimulus package would give the biggest bang per buck if it focused on direct government spending (particularly on timely infrastructure projects) and transfer payments to social security recipients.

Unsurprisingly, he slips in a plug for a $75 a week increase in dole payments to single people and single parents which, because it went to the poorest households in the country, would be spent down to the last penny and on essentials such as food and rent, not imports. It would also go to the poorest regions in the country.

Sounds good to me – and also to Reserve Bank governor Dr Philip Lowe.

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It's the budget, not interest rates, that must save the economy

According to a leading American economist, there are two views of the way governments should use their budgets ("fiscal policy") in their efforts to manage the macro economy as it moves through the business cycle: the old view – which is now wrong, wrong, wrong – and the new view, which is now right.

In late 2016, not long before he stepped down as chairman of President Obama’s Council of Economic Advisers and returned to his job as an economics professor at Harvard, Jason Furman gave a speech in which he drew just such a comparison.

I tell you about it now because, with our economy slowing sharply, but the Reserve Bank fast running out of room to cut its official interest rate so as to stimulate demand, it’s suddenly become highly relevant.

Furman says the old view has four key principles. First, "discretionary" fiscal policy (that is, explicit government decisions to change taxes or government spending, as opposed to changes that happen automatically as the economy moves through the ups and downs of the cycle) is inferior to "monetary policy" (changes in interest rates) as a tool for trying to stabilise the economy.

This is because, compared with monetary policy, fiscal policy has longer "lags" (delays) in being put into effect, in having its intended effect on the economy and in being reversed once the need for stimulus has passed. Scott Morrison’s inability to get his tax cut through Parliament by July 1, as he promised he could, is a case in point.

Second, even if governments could get their timing right, stimulating the economy just when it’s needed, not after the need has passed, discretionary fiscal stimulus wouldn’t work.

It could be completely ineffective because, according to a wildly theoretical notion called “Ricardian equivalence”, people understand that a tax cut will eventually have to be paid for with higher taxes, so they save their tax cut rather than spending it, in readiness for that day. Yeah, sure.

Or it could be partially ineffective because the increased government borrowing need to cover the budget deficit would force up interest rates and thus "crowd out" some amount of private sector investment spending.

Third, use of the budget to try to boost demand (spending) in the economy, should be done sparingly, if at all, because the main policy priority should be long-run fiscal balance or, as we call it in Oz, "fiscal sustainability" – making sure we don’t end up with too much public debt.

Now, I should explain that this view is the international conventional wisdom that eventually emerged following the advent of "stagflation" in the early 1970s, and the great battle between Keynesians and "monetarists" that ensued.

But Furman adds a fourth principle to the old view of fiscal policy: policymakers foolish enough to ignore the first three principles should at least make sure that any fiscal stimulus is very short run, so as to support the economy before monetary stimulus fully kicks in, thereby minimising the harm done.

Remind you of anything? The package of budgetary measures – the cash splashes and shovel-ready capital works – designed mainly by Treasury’s Dr Ken Henry after the global financial crisis in 2008 which, in combination with a huge cut in interest rates, succeeded in preventing us being caught up in the Great Recession, was carefully calculated to be "timely, targeted and temporary".

Furman says that, today, the tide of expert opinion is shifting to almost the opposite view on all four points.

That’s because of the prolonged aftermath of the financial crisis, the realisation that the neutral level of interest rates has been declining for decades, the better understanding of economic policy from the past eight years, the new empirical research on the impact of fiscal policy, and the financial markets’ relaxed response to large increases in countries’ public debt relative to gross domestic product.

Furman admits that this "new view" of the role of fiscal policy is essentially the "old old view" dating back to the Keynesian orthodoxy that prevailed between the end of World War II and the mid-1970s.

Furman outlines five principles of the new view of fiscal policy. First, it’s often beneficial for fiscal policy to complement monetary policy.

This is because the use of monetary policy is constrained by interest rates being so close to zero.

This isn’t new: the real interest rate has been trending down in many countries since the 1980s and was already quite low before the financial crisis.

Second, in practice, discretionary fiscal policy can be very effective. Experience since the crisis shows that Keynesian “multipliers” (where stimulus of $1 adds more than that to GDP) are a lot bigger than formerly thought.

And when you apply fiscal stimulus at a time when private demand is weak, there's little risk of inflation, so central banks won’t be tempted to respond by tightening monetary policy and lifting interest rates, thus countering the fiscal stimulus.

Third, governments have more “fiscal space” to run deficits and increase debt than formerly believed. The economic growth that fiscal stimulus causes means nominal GDP may grow as fast or faster than the increase in government debt.

Partly because of reform, the ageing of the population won’t be as big a burden on future budgets as formerly thought.

Fourth, if government spending involves investment in needed infrastructure, skills and research and development, it not only adds to demand in the short term, it adds to the economy’s productivity capacity (supply) in the medium term.

And finally, when countries co-ordinate their fiscal stimulus – as they did in their initial response to the financial crisis - the benefit to the world economy becomes much greater. This is because one country’s “leakage” through greater imports is another country’s “injection” through greater exports, and vice versa.

It seems clear Reserve Bank governor Dr Philip Lowe understands all this.

But whether the present leaders of Treasury, and Treasurer Josh Frydenberg’s private advisers, have kept up with the research I wouldn’t be at all sure.

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Interest rate cuts may not do much to counter slowdown

This won’t be the only cut in interest rates we see in coming months – which may be good news for people with mortgages, but it’s a bad sign for the economy in which we live and work.

The Reserve Bank is cutting rates because the economy’s growth has slowed sharply, with weak consumer spending and early signs that unemployment is rising.

In such circumstances, cutting interest rates to encourage greater borrowing and spending is the only thing it can do to try to push things along.

Whether we see just one more 0.25 percentage-point cut in a month or two’s time, or whether there will be more after that depends on just how slowly the economy is growing. The Reserve – and the rest of us - will get a much better idea of that on Wednesday morning, when the Australian Bureau of Statistics publishes the quarterly “national accounts”, showing by how much real gross domestic product grew during the first three months of this year.

If you’re thinking that cutting interest rates by a mere 0.25 per cent isn’t likely to make much difference, you’re right. That’s why we can be sure there’ll be at least one more cut.

While it’s true that, with the official interest rate now at a new record low of 1.25 per cent, the Reserve has limited scope for further cuts, don’t expect it to follow the advice from some chief executives that it should refrain from responding to further evidence of weakness in the economy with further cuts so that, once the economy’s reached the point of being really, really weak, the Reserve will still have something left to use to give it life support.

Let’s hope these executives are better at running their own businesses than they are at offering the econocrats helpful hints on how they should be doing their job.

No, we can be confident that, until it believes the economy is picking up, the Reserve will keep doing the only thing it can to help – cutting rates further.

Should this mean the official rate gets to zero, Scott Morrison and his government will then have no choice but finally to respond to governor Dr Philip Lowe’s repeated requests – repeated again only two weeks ago – that they put less emphasis on returning the budget to surplus and more on helping to keep the economy growing, by spending more on needed (note that word) infrastructure and doing it soon, not sometime in the next decade.

Morrison got himself re-elected by claiming to be much better at running the economy than his political opponents. In the next three years we’ll all see just how good he is. Boasting about budget surpluses while unemployment rises is unlikely to impress.

But back to the efficacy of interest rate cuts. Even if we get several more of them, the economy’s circumstances are such that this wouldn’t offer it a huge stimulus.

One part of this is that while interest rates are an expense to borrowers, they are income to lenders, so that a rate cut reduces the spending power of the retired and others. This is always true, but it’s equally true that borrowers outnumber lenders, so the net effect of a rate cut is to increase spending.

In principle, the mortgage payments of households with home loans will now be a little lower, leaving them with more to spend on other things. In practice, many people leave their payments unchanged so they’re repaying the mortgage a little faster.

In principle, lower mortgage rates allow people to borrow more. And moving houses almost always involves increased spending on consumer durables - new lounge suites and the like. In practice, Australian households are already so heavily indebted that few are likely to be tempted to borrow more.

In principle, lower interest rates should also encourage businesses to borrow more to expand their businesses. In practice, what’s constraining businesses from borrowing more is poor trading prospects, not the (already-low) cost of borrowing.

In principle, lower rates are good news for the property market. But the Reserve wouldn’t be cutting rates if it thought the property boom might take off again. Combined with the removal of Labor’s threat to negative gearing, the likely result is a slower rate of fall in house prices, or maybe a floor for them to bump along for a few years. The home building industry won’t return to growth for some years yet.

The rate cuts should, however, cause our dollar to be lower, which may not please people planning overseas holidays, but will give a boost to our export and import-competing industries.

Putting it all together, even if we get a few more rate cuts that isn’t likely to give the economy a huge boost. Which means it’s unlikely to do much to fix the underlying source of the economy’s weakness: very small increases in wages.

The Fair Work Commission’s decision to raise all award minimum wage rates by 3 per cent will help about 2.2 million workers, but few of the remaining 10.6 million are likely to do as well.

Morrison’s promised $1080 boost to tax refund cheques, coming sometime after taxpayers have submitted their annual returns from the end of this month, will provide a temporary fillip, but it's a poor substitute for stronger growth and the improved productivity it helps to bring.

I have a feeling Morrison and his merry ministers will really be earning their money over the next three years.

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Our new economic worry: Reserve Bank running out of bullets

Scott Morrison got the government re-elected on the back of a budget built on an illusion: that the economy was growing strongly and would go on doing so for a decade. The illusion allowed Morrison to boast about getting the budget back into surplus and keeping it there, despite promising the most expensive tax cuts we’ve seen.

The illusion began falling apart even while the election campaign progressed. The Reserve Bank board responded to the deterioration in the economic outlook at its meeting 11 days before the election.

It’s now clear to me that it decided to bolster the economy by lowering interest rates, but not to start cutting until its next meeting, which would be after the election – next Tuesday.

If that wasn’t bad enough for Morrison, with all his skiting about returning the budget to surplus he may have painted himself – and the economy – into a corner.

In a speech last week, Reserve Bank governor Dr Philip Lowe made it clear that cutting interest rates might not be enough to keep the economy growing. He asked for his economic lever, “monetary policy” (interest rates), to be assisted by the government’s economic lever, “fiscal policy” (the budget).

He specifically mentioned the need to increase government spending on infrastructure projects, but he could have added a “cash splash” similar to those Kevin Rudd used to fend off recession after the global financial crisis in 2008.

See the problem? Any major slowdown in the economy would reduce tax collections and increase government spending on unemployment benefits, either stopping the budget returning to surplus or soon putting it back into deficit.

That happens automatically, whether the government likes it or not. That’s before any explicit government decisions to increase infrastructure spending, or splash cash or cut taxes, also worsened the budget balance.

And consider this. The Reserve’s official interest rate is already at a record low of 1.5 per cent. Its practice is to cut the official rate in steps of 0.25 percentage points. That means it’s got only six shots left in its locker before it hits what pompous economists call the “zero lower bound”.

What happens if all the shots have been fired, but they’re not enough to keep the economy growing? The budget – increased government spending or tax cuts – is all that’s left.

The economics of this is simple, clear and conventional behaviour in a downturn. All that’s different is that rates are so close to zero. For Morrison, however, the politics would involve a huge climb-down and about-face.

My colleague Latika Bourke has reported Liberal Party federal director Andrew Hirst saying that, according to the party’s private polling, the Coalition experienced a critical “reset” with April’s budget. The government’s commitment to get the budget back to surplus cut through with voters and provided a sustained bounce in the Coalition’s primary vote.

The promised budget surplus also sent a message to voters that the Coalition could manage the economy, Bourke reported.

Oh dear. Bit early to be counting your chickens.

The first blow during the election campaign to the government’s confident budget forecasts of continuing strong growth came with news that the overall cost of the basket of goods and services measured by the consumer price index did not change during the March quarter, cutting the annual inflation rate to 1.3 per cent, even further below the Reserve’s target of 2 to 3 per cent on average.

Such weak growth in prices is a sign of weak demand in the economy.

The second blow was that, rather than increasing as the budget forecast it would, the annual rise in the wage price index remained stuck at 2.3 per cent for the third quarter in a row. The budget has wages rising by 2.75 per cent by next June, by 3.25 per cent a year later and 3.5 per cent a year after that.

As Lowe never tires of explaining, it’s the weak growth in wages that does most to explain the weakening growth in consumer spending and, hence, the economy overall. Labor had plans to increase wages; Morrison’s plan is “be patient”.

The third blow to the budget’s overoptimism was that, after being stuck at 5 per cent for six months, in April the rate of unemployment worsened to 5.2 per cent. The rate of under-employment jumped to 8.5 per cent.

Why didn’t Labor make more of these signs of weakening economic growth during the campaign? It had no desire to cast doubt on the veracity of the government’s budget forecasts because, just as they provided the basis for the government’s big tax cuts, they were also the basis for Labor’s tax and spending plans.

Labor was intent on proving that its budget surpluses over the next four years would be bigger than the government’s – $17 billion bigger, to be precise.

Think of it: an election campaign fought over which side was better at getting the budget back to surplus, just as a slowing economy and the limits to interest-rate cutting mean that, at best, any return to surplus is likely to be temporary.

Morrison’s $1080 tax refund cheques in a few months will help bolster consumer spending, but they’re a poor substitute for decent annual pay rises.

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Let's stop pretending the old normal is just around the corner

Just as a new chief executive makes sure their first act is to clear out all the stuff-ups left by their predecessor, so a new federal government needs to release its econocrats from the ever-more dubious proposition that nothing in the economy has changed and we’ll soon be back to the old normal.

That’s the old normal of productivity improving by 1.5 per cent a year, the economy growing by 2.75 per cent and wages growing more than 1 per cent faster than the 2.5 per cent inflation rate, with unemployment of 5 per cent and a fat budget surplus rapidly returning the government’s net debt to zero.

That’s the happy fantasy the econocrats have been predicting every year since 2012, the year they helped former treasurer Wayne Swan delude himself he was “delivering” four budget surpluses in a row.

It’s the same fantasy guiding the forecasts in this year’s budget and allowing Treasurer Josh Frydenberg to repeat Swan’s prediction.

A new government would do well to start by freeing itself from the purgatory of endlessly under-achieved forecasts. A re-elected government, of course, would find it much harder to free itself from addiction to the happy pills.

A now highly politicised Treasury seems to have had little trouble keeping this dubious faith that nothing fundamental in the economy has changed and that, every year the return to the old normal fails to happen – we’re up to seven and counting – makes this year’s forecast all the more likely to be the lucky winner.

No, it’s the Reserve Bank and its governor, Dr Philip Lowe, that’s had trouble reconciling the she’ll-be-right forecasting methodology with the daily reality of economic indicators that didn’t get the memo. Unlike Treasury, Lowe has to do it in public – and update his forecasts every quarter, not just twice a year.

The Reserve may be independent when it comes to making decisions about interest rates – though, as we saw last week, not still so independent it’s game to risk pricking the political happy bubble by cutting rates during an election campaign – but it has never allowed itself to be independent of Treasury’s forecasts.

Being bureaucrats, the Reserve’s bosses live in fear of ignorant journalists writing stories about Treasury and the Reserve being at loggerheads. So they never allow their forecasts to be more than a quarter of a percentage point at variance with Treasury’s.

Their bureaucratic minds also mean they prefer to initiate rate changes in February, May, August or on Melbourne Cup day, so their move can be justified in the quarterly statement on monetary policy published the following Friday.

All this does much to explain the contortions Lowe put himself through last week. Everything the Reserve said about the immediate outlook for the economy implied it should have begun cutting last week.

It slashed its forecasts for consumer spending, inflation and GDP for the rest of this calendar year, which of itself was enough to justify an immediate cut. Last Tuesday it told us enigmatically it “will be paying close attention to developments in the labour market”, but three days later forecast that unemployment would be unchanged at 5 per cent for the next two years.

What Lowe hasn’t explained is that the only thing in the labour market that would stop him cutting rates in the next few months is if unemployment were to fall. That’s because the one respect in which he’s broken free of the Treasury orthodoxy is his acknowledgement, before a parliamentary committee, that the best estimate of full employment (the “non-accelerating-inflation rate of unemployment”) has dropped from about 5 per cent to about 4.5 per cent. If you’re not heading down to 4.5 per cent, why aren’t you cutting?

Trouble is, if full employment is 4.5 not Treasury’s 5, that means our “potential” growth rate is likely to be below Treasury’s 2.75 per cent (including its assumption of 1.5 per cent annual improvement in productivity). And, if that’s so, then our “output gap” will be less than the 1.25 percentage points that Treasury uses to justify its projection that the economy will grow for five years in a row at 3 per cent, before dropping back to 2.75 per cent a year.

The trick to Treasury’s forecasting is that, though it always cuts its immediate forecasts to accommodate the latest disappointment in the actual data, its mechanical projections assume “reversion to the mean”, so its later forecasts have to rise to meet the start of the we’re-back-to-normal projections. But it’s always the old mean we'll be reverting to, not any new one.

Now get this: measured on a consistent “year-average” basis, the Reserve’s latest “slashed” forecasts differ in no significant way from those Treasury put in this year's budget. When it comes to forecasting, the Reserve is slave to a politicised Treasury.

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Interest rate cuts are coming, which isn't good news

The Reserve Bank may have decided not to cut interest rates right now, but it’s likely to be only a few months before it does start cutting, and it’s unlikely to stop at one. So, is it just waiting until after the election? I doubt that’s the reason.

The Reserve has moved interest rates twice during election campaigns – raising them in 2007 (much to the surprise of Peter Costello, whose mind was on politics at the time) and cutting them in 2013 – so, had Reserve governor Dr Philip Lowe considered an immediate cut was needed, I doubt he would have hesitated to make it.

The Reserve acts independently of the elected government, so it is – and must be seen to be - apolitical. Lowe’s predecessor, Glenn Stevens – who instigated both those previous moves – decided that the only way to be genuinely apolitical was for him to act as soon as he believed the best interests of the economy required him to, regardless of what the politicians were up to at the time.

I doubt his former deputy and understudy, Lowe, would see it any differently.

So, is Lowe’s judgement that a rate cut isn’t needed urgently bad news or good for Scott Morrison – or, conversely, for Bill Shorten?

First point: stupid question. What matters most is whether it’s good or bad news for you and me, and the economy we live in, not the fortunes of the people we hire to run the country for us. The rest is mere political speculation.

The media invariably judge a fall in interest rates to be good news and a rise bad news. But this is far too narrow a perspective. For a start, it assumes all their customers have mortgages and none are saving for a home deposit or for retirement. The retired are absolutely hating the present protracted period of record low interest rates.

For another thing, it assumes that our loans or our deposits are the only things that matter to our economic wellbeing. That the central bank’s movement of interest rates has no implications for, say, our prospects of getting a decent pay rise, or of hanging onto our job.

The fact is that central banks use the manipulation of interest rates to influence the rate at which the economy’s growing. They raise rates when everything’s going swimmingly and, in fact, needs slowing down a bit to keep inflation in check.

They cut interest rates when things aren’t going all that well – when, for instance, low wage increases are causing anaemic growth in consumer spending and this is giving businesses little incentive to expand their operations, or when a rise in unemployment is threatening.

Penny dropped? A cut in interest rates is a portent of tougher times ahead, whereas a rise in rates says the good times are rolling and will keep doing so for a while yet.

So it’s not at all clear that, had he cut rates, Lowe would have been doing Morrison a favour politically and doing Shorten a disservice.

In Treasurer Josh Frydenberg’s budget speech a month ago – it seems an eternity – he used the phrase “strong growth” 14 times. Turned out Morrison was basing his case for re-election on the claim that the Coalition had returned the economy to strong growth – after the mess those terrible unwashed union people had made, as they always do.

That claim is now not looking so believable. It was in trouble even before the budget, when we learnt in March that the economy had suffered a second successive quarter of weak growth, slashing the rise in real gross domestic product during 2018 to just 2.3 per cent – rather than the 3 per cent the Reserve had been talking about.

This was the first sign that, having left its official interest rate steady at 1.5 per cent for more than two and a half years, the Reserve needed to think about using a cut in rates to help push the economy along.

The next sign came just a fortnight ago, when the release of the consumer price index showed that, while some prices fell and others rose during the March quarter, on balance there was no change in the cost of the typical basket of goods and services bought by households.

This caused the annual rate of price increase to fall from 1.8 per cent to 1.3 per cent – at a time when the Reserve had gone for more than three years assuring us it would soon be back in the Reserve’s target range of between 2 and 3 per cent.

So, quite a blow to the Reserve’s assurances that the economy was getting stronger, and a sign it should be thinking seriously about cutting rates to kick things along. (Prices tend to rise faster the faster the economy is growing so, paradoxically, very low inflation is a worrying sign.)

In which case, why has Lowe hesitated? Because, I suspect, he’s waiting for the third shoe to fall. Employment has been growing faster than you’d expect in a weak economy, so he may be waiting for signs it’s slowing, too.

And he’d want to be confident a cut in interest rates didn’t restart the housing boom in Sydney and Melbourne, which has left too many people with far too much debt.

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Top economy manager wants you to get bigger pay rises

This year more than usually, if you want straight talking about the state of the economy and its prospects, listen to the econocrats not the election-crazed politicians.

Late last week, Reserve Bank governor Dr Philip Lowe had more sensible things to say in three hours than we usually get in a month.

He was giving evidence to the House of Representatives standing committee on economics. For a start, he left little doubt about his disapproval of the way the two sides are turning the election campaign into a bidding war.

It’s clear the reason the election is being delayed until May is so Scott Morrison can use the April 2 budget to announce tax cuts in addition to the three-stage, $144 billion-over-10-years cuts he announced in last year’s budget.

He’s upping the ante not just because he’s behind in the polls, but also because Bill Shorten is promising to make the first-stage cuts about twice the size of Morrison’s. And big increases in spending on health and education.

Plus Shorten is claiming he’d have bigger budget surpluses. How? By reducing tax breaks used mainly by higher income-earners. The risk, however, is that Labor could get locked into cutting taxes and increasing spending, but not be able to get its revenue-raising measures through the Senate.

What would be worrying Lowe is that, just as we’ve come within sight of returning the budget to (tiny) surplus – but before we’ve made any progress in repaying the huge debt successive governments have racked up over the past decade – both sides have declared Mission Accomplished and started promising tax cuts galore.

Lowe said we should be running big budget surpluses and cutting back the debt as a sort of insurance policy against the next downturn in the economy – which he doesn’t see happening in the next year or two, but will happen one day.

Consider this. When the global financial crisis hit in October 2008, Lowe’s predecessor acted to protect us from the tsunami by cutting the official interest rate by 4 percentage points in about as many months.

Trouble is, we’ve since entered a low growth, low inflation world, and interest rates have remained low. The official interest rate is just 1.5 per cent. So the central bank has little scope to stimulate the economy the way it did last time.

In that case, the government should use its budget to stimulate the economy by splashing cash, spending on school playgrounds and the like.

See the problem? We won’t have much scope to do that, either, if we’ve been so busy awarding ourselves tax cuts that we’ve made little progress in reducing all the debt we’ll be starting with.

Moving on, Lowe said the economy’s two main worries were the weak growth in wages and falling house prices. But he stressed that wages and household income were far more significant than house prices.

If you were thinking it was the other way round, that may be because the media have misled you. “It’s largely the income story which doesn’t get talked about enough, because the media love talking about property prices,” he said.

Whereas household income, coming mainly from wages, used to grow by about 6 per cent a year (before allowing for inflation), in recent years it’s grown by less than 3 per cent.

Lowe didn’t say it, but what economists see as weak growth in wages, most ordinary mortals perceive as the worsening “cost of living” – which polling shows is now voters’ greatest concern.

People are having trouble balancing their own budgets, not because prices generally are soaring, but because their wages aren’t growing a per cent or two faster than prices, the way they used to.

Lowe is confident wages will gradually improve, but “if we have another five years where workers don’t get their normal share of productivity growth [that is, if wages don’t return to growing a per cent or so faster than prices each year], we’ll have all sorts of economic, social and political problems”.

Gosh. He did have some good news, however. He’s confident employment will continue growing strongly because the rate of job vacancies is higher than it’s ever been.

And whereas economists have long believed the rate of unemployment couldn’t fall below “about 5 per cent” before we started getting excessive wage settlements and rising inflation, Lowe now believes unemployment can fall further to “about 4.5 per cent” before there’s a problem. (May not sound much to you, but it gives us scope for 67,000 more jobs.)

Lowe says there’s more competition between the big banks than we’re told about. Remember a few months ago when they raised their mortgage interest rates by between 0.1 and 0.15 percentage points?

That’s what they told the media and what they wrote on their price lists. In truth, however, rates rose by only 0.03 or 0.04 points. Why? Because too many of their customers threatened to take their business elsewhere.

Finally, some free advice from the nation’s most powerful economist: “I encourage everyone who has a mortgage, if they haven’t done so recently, to go and ask their bank for a better deal. And if the bank says no, go look for another bank.”

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The economy isn’t in trouble, but let’s cut interest rates anyway

Rather than merely acknowledging that the next move in interest rates is as likely to be down as up, I think the Reserve Bank should get on with cutting them. But not for the reason you may imagine.

There are plenty of people – many of them in the media – silly enough to believe a fall in interest rates is always good, and a rise always bad. They have a mortgage-centred view of the universe.

They forget that lower rates are bad news for people living off their savings – or saving for a home deposit.

More particularly, they forget that central banks use interest rates to keep the economy on an even keel. Judged the conventional way, central banks cut interest rates when they judge the economy to be weak or weakening.

So, even for those with mortgages, a cut in rates is no reason to celebrate. They’ll be paying less interest, sure, but only because, in the econocrats’ judgement, there’s now a greater risk they’ll lose their job, be put on a short working week, or go for year or two without a pay rise.

Is that what you’re hoping for? I’m not. Nor do I think it’s our certain fate. The biggest risk we face is talking ourselves into a downturn – for no better reason than it would be something new to talk about.

Telling ourselves that a fall in house prices – something we’ve experienced many times before and lived to tell the tale – is the start of an avalanche.

Or, when Reserve Bank governor Dr Philip Lowe moves from saying the next move in rates is up, to saying the chances are evenly balanced between up and down, leaping to the conclusion he’s really saying a cut is imminent.

It isn’t. It isn’t because, as he made plain in a speech on Wednesday – and reiterated in the statement on monetary policy on Friday – he remains confident the economy has slowed a bit, but no worse. His revised forecast is for the economy to grow by an above-trend 3 per cent this year.

And a rate cut isn’t imminent because he said it wasn’t. “[The board] does not see a strong case for a near-term change in the cash rate. We are in the position of being able to maintain the current policy setting while we assess the shifts in the global economy and the strength of household spending.”

He also said that “what we are seeing looks to be a manageable adjustment in the housing market”.

So a rate cut isn’t imminent. According to Lowe, a cut would require “a sustained increase in the unemployment rate”. Which, judged by conventional standards, is good news. It means he believes the economy will continue plugging on.

But my point is different. Lowe is pursuing a conventional, business-as-usual approach to managing the economy because he assumes nothing fundamental has changed.

His conventional thinking is that it’s weak wage growth that’s driving the economy’s relative stagnation. It hasn’t occurred to him it’s the other way round: the economy’s stagnation is the cause of weak wage growth.

I think it’s clear the phenomenon of “secular (that is, long-lasting) stagnation” – exceptionally low inflation, low wage growth, low real interest rates, low business investment, low productivity improvement and low economic growth – applies to our economy as well as to the United States and the other advanced economies.

Every symptom on that list applies to us (bar the long-past mining investment boom). And stagnation isn’t a bad way to describe our position, where growth over the 10 financial years since the global financial crisis has averaged less than 2.6 per cent a year and only one year (2011-12) has been above trend.

One thing that’s become clear in America and other advanced economies is that secular stagnation – the causes of which economists are still debating – has caused conventional estimates of the NAIRU (“non-accelerating-inflation rate of unemployment” – the lowest rate to which unemployment can fall before wage and price inflation begin to worsen) to be far too high.

In those countries, unemployment has fallen well below where the NAIRU (sounds a bit like the island) was thought to be, without any sign of price inflation or excessive wage growth.

The same can be said of us. The Reserve estimates our NAIRU to be “about 5 per cent”. Our actual unemployment rate has been at 5 per cent or so for some months, while the latest reading for underlying inflation is 1.75 per cent and for the wage price index is 2.2 per cent.

So, we’re at the supposed NAIRU without the slightest sign of inflation pressure. Indeed, underlying inflation has been below the 2 to 3 per cent target range since the end of 2015, and Lowe is forecasting it won’t get up into the target range until the end of next year.

This suggests that, in our newly stagnant world, the true NAIRU is a lot lower: 4.5 per cent, maybe 4 per cent. And since, as Lowe reminds us, the RBA’s objectives include “delivering on full employment”, he should be trying harder to get unemployment down to the true NAIRU.

How? By using the one instrument available to him: cutting interest rates to loosen a monetary policy that’s tighter than it needs to be.

Until recently, Lowe’s best reason for not lowering rates was a desire to avoid adding fuel to the boom in house prices (“asset-price inflation”). But now that constraint has lifted, there’s no reason to hesitate.

You could argue that, with households already so loaded with debt, a rate cut may not do much to boost consumer spending. But it probably would lower the dollar, which would improve our industries’ price competitiveness internationally, encouraging them to hire more workers. We’ve got little to lose.

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How we killed off Australia's inflation problem

Before we let 2018 go, do you realise it’s the 25th anniversary of the introduction of the Reserve Bank’s target to achieve an inflation rate of between 2 and 3 per cent? It’s a milestone worth celebrating.

Why? Because it’s worked so well. For the past quarter century, we’ve had inflation that has fallen within the target range “on average, over time” and hence been low and stable.

This week the Reserve Bank issued a volume of papers from its conference to discuss inflation targeting, and whether it needed to change. (Conclusion: it didn’t.)

In that 25 years we haven’t had a serious worry about inflation – which certainly can’t be said of the 20 years before the target was unveiled in 1993.

In those earlier years we were continually worried about high inflation. It reached a peak of 17 per cent in the mid-1970s, averaged about 10 per cent for that decade and 8 per cent during the 1980s.

All the other advanced economies had high inflation rates at the time, but ours was higher and took longer to fix.

Our problem was usually linked with excessive growth in wages, and the “wage explosions” of the mid-1970s and early 1980s prompted the authorities to jam on the brakes, leading inevitably to severe recessions.

Even though inflation remained high, a third and more severe recession in the early 1990s was more the consequence of the authorities’ overdone attempt to end a boom in commercial property prices.

It’s not by chance that this year we reached 27 years of continuous growth since that recession. Before it, we had recessions about every seven years, all of them caused by the authorities jamming on the brakes – and then, when we crashed into recession, stepping on the accelerator, a “stop/go policy”.

The first reason we haven’t needed to worry much about inflation since then is that, as part of the adoption of the inflation target, responsibility for setting interest rates was moved from the politicians to the econocrats running an independent central bank.

They’ve been a much steadier hand on the interest-rate lever, moving rates up or down according to the needs of the business cycle, not the political cycle.

Another reason we’ve stopped worrying about inflation is that this year is also the 35th anniversary of the floating of our dollar in 1983. A floating exchange rate – which, remarkably, has almost always floated in the direction needed to keep the economy on an even keel – has made it a lot easier for the Reserve to keep inflation low and stable.

A third reason is the extensive program of “micro-economic reform” begun by the Hawke-Keating government in the 1980s – including the deregulation of many industries and the decentralisation of wage-fixing – which has made our economy much less inflation-prone than it used to be.

Yet another factor was the realisation at the time the inflation target was adopted – informally by the Reserve in 1993, and then formally by the incoming Howard government in 1996 – that the key to lower inflation was to get “inflation expectations” down to a reasonable level.

Why? Because there’s a strong tendency for the expected inflation rate in the minds of shopkeepers and union officials to become a self-fulfilling prophecy. If they expect prices to keep rising rapidly, they get in first with their own big price or wage rises.

We’ve spent the past 25 years demonstrating that if you can get everybody expecting inflation to stay low, you have a lot less trouble ensuring it actually does.

The hard part was how to get from the high expectations of the late-1980s to the low expectations we’ve had for most of the past 25 years.

Bernie Fraser, Treasury secretary turned Reserve Bank governor, the man who introduced the target, knew what to do: define what was an acceptably low inflation rate – between 2 and 3 per cent, on average - and keep the economy comatose until you actually achieved the target, then keep it low until everyone had been convinced that “about 2.5 per cent” was what today we’d call “the new normal”.

How did Fraser achieve this? He did the opposite of what his predecessors did whenever they realised they’d hit the economy harder than they’d intended to. Despite knowing we were in for a bad recession, he let the interest-rate brakes off only slowly, and didn’t hit the accelerator.

In other words, he made the recession of the early ‘90s longer and harder than it could have been. I think he decided that, since we were in for a terrible belting anyway, he’d make sure we at least emerged from the carnage with something of value: a cure for our inflation problem that wasn’t just temporary, but lasting.

And that’s what he delivered. With low inflation expectations embedded, he was able to stimulate the economy to grow faster and get unemployment down. It went from 11 per cent after the recession to 5 per cent today.

At the time the inflation target was adopted, some people worried it meant the Reserve didn’t care about unemployment. As events have demonstrated, that was wrong. To Fraser, low inflation was just a means to the ultimate end of low unemployment.

I rate him the best top econocrat we’ve had in 50 years. He was wise and caring, with the best feel for how the economy worked. Peter Costello gets the credit for formally adopting Fraser’s inflation target, pursued by an independent Reserve Bank.

But another person also deserves credit – Dr John Hewson. It was Hewson who, as Coalition shadow treasurer, made the most noise about the need for an independent central bank with an inflation target.

Fraser decided he’d better get on with specifying his own target before “some dickhead minister” tried to impose a crazy one on him.

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