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

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.


Wednesday, September 28, 2022

Great Aussie Pipedream: rising house prices make us feel wealthier

I guess you’ve heard. Isn’t it great? Australians are now the richest people in the world. But if you find that hard to believe, congratulations. Your bulldust detector’s working fine.

According to Credit Suisse’s annual global wealth report, which tracks wealth in 20 countries, last year the typical adult Australian’s wealth – assets minus debts – reached almost $336,000.

Soaring property prices lifted our median wealth by $38,000, enough to put us just ahead of Belgium and New Zealand. Our residential property prices rose by almost 24 per cent during the year.

We had about 2.2 million millionaires – measured in US dollars – up from 1.8 million in 2020.

So, what’s the catch? Well, I’m sure there’s nothing wrong with the bank’s calculations. And there’s no denying we’re a rich country, whether by this you mean our annual income, or the value of the net assets, physical and financial, of our households.

No, the problem is that so much of our wealth comes from the value of our home. Do you believe our homes are so much bigger or better, or better located, than homes in North America or Europe?

I doubt it. If not, then what we’re really saying is that the land on which our homes are built is much better than the land on which the Americans and Germans – and Kiwis – have built their homes.

Really? We have better views? Better soil quality? Less chance of getting flooded or burnt out?

No. If the market price of our residential land is higher than their market price, it’s just because we’ve bid our prices up higher than they have theirs.

And how exactly does doing that make Australians richer than people in other countries? If it does, why don’t we keep bidding our prices up until we’re twice as rich as we are now?

See what I’m saying? It’s not something economists talk about much but, as former Reserve Bank heavy Dr Tony Richards explained in a speech many moons ago, the notion that the high prices we charge and pay each other for our homes makes the nation richer is an illusion.

“The increase in housing prices has been a mixed blessing for Australians. At one level, rising housing prices have made many people feel [note that word] wealthier and have contributed to higher levels of consumer spending than might otherwise have occurred. But they have also resulted in concerns about housing affordability,” he said.

“The difference in views reflects the fact that housing is not just an asset but also a consumption item. When housing is thought of purely as a consumption item, it would seem that in aggregate we would be better off if its price were lower.

“Because we all need to consume some level of housing services, either rented or purchased, a higher level of housing prices and rents allows less spending on other items.”

Get it? It seems that, as a nation, Australians value owning their own home, and making sure it’s a good one, more than the people in many other rich countries do.

In consequence, we devote more of our incomes to housing than they do, meaning we spend a smaller proportion of our incomes on everything else. So, to that extent, home ownership really is the Great Australian Dream.

It’s because, as a nation, we can never spend enough on improving our own housing position – although how much we can pay is held back by how much our income allows us to borrow – that house prices have become so sensitive to the rate of interest on home loans.

When rates come down a bit – even during a pandemic – our ability to borrow more prompts more aggressive bidding against other would-be owners, pushing prices up. When, as now, interest rates start going up again, thus reducing how much we can borrow, house prices fall back a bit.

Although there’ve been times when we’ve let our building of extra homes fall behind the growth in our population, over the longer term we’ve managed to keep the two pretty much in line.

So, house prices aren’t high because we don’t have enough houses to accommodate every household. They’re high because some houses are better than others – bigger, newer, flashier, or better located, nearer the beach, nearer other well-off people, or nearer the centre of the city – and we compete with others to get the best we can (barely) afford. And because many home owners want to own more than one, as an investment.

As well, prices in the most desirable parts of the city are higher because of government restrictions on packing in more households by building up rather than out.

But here’s the punchline. Just because higher house prices don’t make us wealthier as a nation, this doesn’t stop them making some Aussies wealthier than other Aussies. Which, for many of us, is what we’re after. Housing is one of the main things we’ve allowed to widen the gap between rich and poor.

And I thought we were supposed to be proud of our Aussie egalitarianism.


Wednesday, February 12, 2020

The Great Australian Dream is keeping the economy weak

Do you worry about the enormous size of your mortgage? If you do, it seems you’re not the only one. And the way Reserve Bank governor Dr Philip Lowe sees it, people like you are the main reason consumer spending is so weak and the Reserve and the Morrison government are having so much trouble getting the economy moving.

Until the global financial crisis in 2008, we were used to an economy that, after allowing for inflation, grew by about 3 per cent a year. The latest figures show it growing by barely more than half that. (This, of course, is before we feel the temporary effects of bushfires and the coronavirus.)

This explains why the Reserve cut its official interest rate three times last year, dropping it from a record low of 1.5 per cent to an even more amazing 0.75 per cent. Cutting interest rates is intended to encourage people to borrow and spend. So far, however, it’s shown little sign of working.

Similarly, the first stage of the massive tax cuts that were Scott Morrison’s key promise at last year’s election, a new tax break worth more than $1000 a year to middle-income-earners, was expected to give the economy a kick along once people started spending the much bigger tax refunds they got after the end of last financial year.

Despite Treasurer Josh Frydenberg’s confident predictions, it didn’t happen. Why have the authorities had so little success at pushing the economy along? Why did real consumer spending per person actually fall in the year to September?

That’s what Lowe sought to explain to the House of Reps economics committee last Friday. His theory – which he backed up with statistical evidence – is that, the combination of weak growth in wages with falling house prices has really worried a lot of people with big mortgages.

So, rather than increase their spending on goods and services, they cut it and used whatever spare money they could to pay down their mortgage.

In principle when interest rates fall, people with home loans now have more money to spend on other things. In practice, however, most people leave their monthly payments unchanged. The amount they’re paying above the bank’s newly reduced minimum payment comes straight off the principal they owe, thus further reducing (by a little) the interest they’re charged.

That’s pretty much standard behaviour for Australian home-buyers. But this time they’ve also avoided spending their tax refunds, leaving the money in their “offset account”. They may or may not decide to spend it later. But for as long as it’s sitting in the offset account it’s reducing their net mortgage debt and the interest they’re paying.

But get this: not content with those two moves, households have also decided to cut their consumer spending and so save a higher proportion of their income. It’s a safe bet that people with home loans have got that extra saving parked in their offset accounts.

Lowe makes the point that, when worried home-buyers take money sent their way to get them spending and use it to reduce their debt, this does bring forward the day when they feel confident enough to start spending again. That’s true, but very much second prize.

If people with mortgages are feeling anxious, that’s hardly surprising. By June last year, household debt reached a record 188 per cent of annual household disposable income, before falling a bit in the September quarter (see above). About half that debt was for owner-occupied housing and about a quarter for personal loans and credit cards, leaving about a quarter for housing investment debt.

This is higher than in most rich countries, but that’s mainly because of our generous tax breaks for negatively geared property investors, a loophole most other, more sensible countries have closed.

But hang on. Those of us living in Melbourne or Sydney (but not elsewhere in Australia) know that, in response to the recent cuts in interest rates, people have resumed borrowing for housing, causing house prices to stop falling and start rising again.

Is this a good thing? Lowe can see advantages and disadvantages. On the plus side, rising house prices are likely to make people with big mortgages feel less uncomfortable and so get closer to the point where they allow their spending to grow. It also brings forward the day when the building of new homes stops falling and starts rising again.

On the negative side, is it really a great thing for house prices to take off every time interest rates come down? How’s that going to help our kids become home owners?

Lowe asks whether we benefit as a society from having very high housing prices relative to the level of our incomes. “There are things that we could do on the structural side . . . to have a lower level of housing prices relative to income.” They’re much lower across the United States, for instance, even though, by and large, the Americans’ interest rates have been lower than ours.

What are these “things on the structural side” we could be doing to make our housing more affordable? He didn’t say. But I think he was referring to more liberal council zoning regulations and to getting rid of the many tax concessions that favour home owners at the expense of would-be home owners, including negative gearing.

Saturday, February 14, 2015

How cutting interest rates affects demand and inflation

Although many people have their doubts, the Reserve Bank cut interest rates last week believing it would help the economy grow faster and reduce unemployment. But how exactly is this meant to work?

Monetary economists believe interest rates affect the strength of demand (spending) in the economy via several "channels" or mechanisms. Eventually the effect on demand affects the degree of pressure for higher prices.

As we work through these channels we'll see why some people didn't want interest rates to be cut further, why some believe monetary policy (the manipulation of interest rates) is at a point where it's less effective and why others (such as me) believe the further cut risks fuelling a house-price bubble.
The first channel goes by the fancy name of the "inter-temporal substitution" effect. Inter-temporal means "between time periods" and it's making the point that the rate of interest is the opportunity cost of choosing to spend now rather than later.
If you want to buy a car but don't have the money to pay for it, the cost of buying it now rather than waiting until you've saved the money is the interest you pay on the loan. But even if you already have the money in the bank to buy the car, the opportunity cost of buying it now rather than later is the bank interest you forgo by taking your money out.

So when the Reserve brings about a fall in interest rates it's hoping the lower cost of borrowing (or the lower opportunity cost of reducing the money in your bank account) will encourage households and businesses to bring forward their spending on consumer durables and assets from a future period to the present period. This is inter-temporal substitution.

The next channel is the cash flow effect. In principle, cutting interest rates reduces monthly mortgage payments, leaving people with more cash to spend on other things. Equally, the lower repayments make it easier for would-be home buyers to go ahead.

Remember, however, that although almost all businesses have debts, only about a third of households have mortgages. Roughly a third have paid off their homes, leaving about a third renting.

This suggests that about two-thirds of households are "net lenders" (they have more money in bank accounts and the like than they owe on credit cards and personal loans), leaving only a third of households as "net borrowers".

But as any retiree will unhappily remind you, a fall in interest rates might be good news for borrowers, but it's bad news for lenders. So about two-thirds of households (including oldies and young people saving for a house deposit) will be left with less cash to spend on goods and services.

It's true, however, that the remaining third of households gain more overall than the two-thirds lose, because the amount they owe exceeds the amount the two-thirds have in bank accounts and securities.

This is why you'd expect the cash flow channel to be a further mechanism that, in net terms, was encouraging spending and growth. Trouble is, a high proportion of people with home loans leave their monthly mortgage payments unchanged despite the fall in rates. That is, they don't spend their saving in interest, they save it.

A third channel by which a cut in interest rates should hasten economic growth is the exchange rate effect. When our interest rates fall relative to other countries' rates - thus reducing our "interest rate differential" - this should make bringing foreign funds into Australia less attractive and so reduce the demand for Aussie dollars, causing it to fall relative to other currencies.

A lower dollar makes Australian businesses more price competitive by making our exports cheaper to foreigners and imports dearer to Australians. This should encourage greater Australian production of goods and services, increasing employment.

It's a nice, neat chain of logic but, as the Reserve notes in its description of the monetary channels on its website, they are "far from mechanical in their operation". Lots of other factors affect our exchange rate beside the interest differential.

There's a strong, but far from automatic, correlation between our dollar and the prices we get for our commodity exports. Our exchange rate is also affected by the things our trading partners do in their economies, such as manipulating their exchange rate by engaging in "quantitative easing".

Don't forget, our dollar was falling during the 18 months that our interest rates were unchanged.

Even so, my guess is that trying to keep the Aussie's recent downward momentum going was a big part of the Reserve's reason for cutting rates last week. It knows forex markets are affected by speculation and bandwagon effects that don't get much coverage in textbooks.

Another part of the channels story is that cutting the return on safe financial investments such as bank accounts has the effect of encouraging individuals and businesses to seek higher returns by buying riskier assets. Retirees move from bank term deposits to shares, while some households respond to lower interest rates by buying negatively geared investment properties.

Lower rates lead to more borrowing to buy houses, which pushes up house prices. Rising house prices encourage more people to buy, particularly investors seeking capital gain. If you're not careful this becomes a house price bubble that inevitably ends in tears.

Left out of the standard story about the channels through which lower interest rates cause faster growth is that the era of greater reliance on monetary policy has also been the era of credit-fuelled asset price booms and busts. As witness, the global financial crisis.

Why did the Reserve wait 18 months before cutting interest rates to a new low? Because it knows it's running a high risk of sparking a housing boom and bust. But with the economy now so weak, it felt it had no choice.

Monday, October 13, 2014

Interest rates to stay low, but lending curbs loom

With the Reserve Bank worried by fast-rising house prices, but the dollar coming down and the unemployment rate now said to be steady, can a rise in the official interest rate be far off? Yes it can.

On the face of it, last week's revised jobs figures have clarified the picture of how the economy is travelling. The national accounts for the March and June quarters show the economy growing at about its trend rate of 3 per cent over the previous year, which says unemployment should be steady.

And now the jobs figures are telling us the unemployment rate has been much steadier than we were previously told, at about 6 per cent.

If economic growth is back up at trend, we need only a little more acceleration to get unemployment falling. The Reserve is clearly uncomfortable about keeping interest rates at 50-year lows while rapidly rising house prices tempt an already heavily indebted household sector to add to its debt.

So, surely it's itching to remind us that rates can go up as well as down and, in the process, let some air out of any possible house-price bubble.

Well, in its dreams, perhaps, but not in life. Even if hindsight confirms the latest reading that the economy grew at about trend in 2013-14, the Reserve knows it can't last. Its central forecast of growth averaging just 2.5 per cent in the present financial year is looking safer, maybe even a little high.

The sad fact is that a host of factors are pointing to slower rather than faster growth in 2014-15, implying a resumption of slowly rising unemployment and no scope for even just one upward click in interest rates.

The biggest likely downer is the long-feared sharp fall in mining investment spending. To this you can add weak growth consumer spending, held back by weak growth in employment and unusually low wage rises.

Now add the point made by Saul Eslake, of Bank of America Merrill Lynch, that real income is growing a lot more slowly than production, thanks to mining commodity prices that have been falling since 2011.

Weak growth in income eventually leads to weaker growth in production, which, in turn, is the chief driver of employment. With the Chinese and European economies' prospects looking so poor, it's easy to see our export prices falling even faster than the authorities are forecasting.

Real gross domestic income actually fell in the June quarter, and Eslake sees it falling again in the September quarter.

Apart from the recovery in home building, pretty much the only plus factor going for the economy is the recent fall in the dollar, bringing relief to manufacturers, tourist operators and others.

But measured on the trade-weighted index, the Aussie is back down only to where it was in February, and since then export prices have fallen further, implying the exchange rate is still higher - and thus more contractionary - than it should be.

In other words, the usually strong correlation between the dollar and our terms of trade has yet to be restored. Why hasn't it been in evidence? Because our exchange rate is a relative price, affected not just by what's happening in Oz but also by what's happening in the economy of the country whose currency we're comparing ours with.

The Aussie has stayed too high relative to the greenback not because our interest rates have been too high relative to US rates, as some imagine, but because one of the chief effects of all the Americans' "quantitative easing" has been to push their exchange rate down.

As the US economy strengthens and the end of quantitative easing draws near - and, after that, rises in their official interest rate loom - the greenback has begun going back up. The prospects of it going up a lot further in coming months are good.

That's something to look forward to. But our exchange rate would have to fall a long way before it caused the Reserve to reconsider its judgment that "the most prudent course is likely to be a period of stability in interest rates".

But that still leaves the real risk of low rates fostering further rises in house prices, particularly in Sydney and Melbourne.

What to do? Resort to a tightening of "macro-prudential" direct controls over lending for housing. The restrictions may be announced soon, be aimed at lending for investment and even limited to borrowers in the two cities.

But though they'd come at the urging of the Reserve, they'd be imposed by the outfit that now has that power, the Australian Prudential Regulation Authority.

Saturday, March 2, 2013

How Reserve Bank retains control of interest rates

When the banks began moving their mortgage and other lending rates at variance with the Reserve Bank's changes in its official interest rate, many people took this as a sign the Reserve had lost its ability to control market interest rates, making its monetary policy ineffective.

Fortunately for all of us, this impression was wrong. That so many people came to this conclusion showed their grasp on the mechanics of monetary policy (the central bank's manipulation of interest rates to influence the strength of demand in the economy) was shaky.

But this week one of the Reserve's assistant governors, Dr Guy Debelle, gave us all a little tutorial in a speech to a business school breakfast.

On Tuesday (and on the first Tuesday of every month bar January), the board of the Reserve meets to determine the appropriate "stance" (setting) of monetary policy. The decision takes the form of a target for the official rate (known in the trade as the "cash" rate). Sometimes the target is moved down a little, sometimes up a little, but mainly it's left where it is.

How does the Reserve unfailingly achieve the target? Settle back. The cash rate is the interest rate the banks charge each other to borrow and lend funds overnight.

Every bank has an account with the Reserve called its "exchange settlement account". Just about every monetary transaction in the economy goes through these accounts. As Debelle explains, when you pay your electricity bill by direct debit, the funds are effectively transferred from your bank account, across the exchange settlement account of your bank to that of your electricity company's bank and into the electricity company's account.

All these transactions mean the balance in each bank's exchange settlement account goes up and down throughout the day. But the Reserve requires each bank to ensure its account always has a positive balance. Banks that leave funds in their account overnight are paid interest at a rate 0.25 percentage points below the cash rate, whereas banks that look like having a negative balance may borrow the difference from the Reserve overnight at a rate 0.25 percentage points above the cash rate.

Get it? These penalties are designed to encourage the banks to borrow and lend to each other overnight at the (more attractive) cash rate.

The Reserve's ability to control the cash rate arises because it has complete control over the supply of funds in this market. It ensures there is just sufficient supply to meet the demand for funds at the interest rate it is targeting.

Where an increase in demand threatens to push the interest rate up, it will use its "open market operations" to increase the supply of funds just sufficiently to keep the rate where it wants it. Where a fall in demand for funds threatens to push the rate down, the Reserve will reduce the supply to ensure the rate doesn't change.

Historically, the Reserve would increase the supply of cash by buying second-hand government bonds from the banks and paying for them with cash. (Note that in this context, "cash" doesn't mean notes and coins, it's a nickname for the funds in exchange settlement accounts.)

Conversely, it would reduce the supply of funds by selling bonds to the banks, which they had to pay for from their exchange settlement accounts. These days, however, the Reserve achieves the same effect using repurchase agreements ("repos").

The main reason for fluctuations in the overall daily demand for exchange settlement funds is transactions involving the Reserve's one big banking customer, the federal government. Demand will rise on days when the government's receipts from taxation exceed its payments of pensions and all the rest. Demand for cash will fall on days when the government's payments exceed its receipts.

All this ensures the Reserve has a vicelike grip on the cash rate. And this gives it the ability to influence all the other interest rates in the economy. Why? Because the cash rate is, in effect, the anchor point for all other rates.

Banks fund only a very small part of their operations in the cash market, Debelle explains, but all their funding could be done from that market if they wanted to. The rate at which they're prepared to borrow for periods longer than overnight is the averaged expected path of the cash rate over the life of the loan plus various margins for risk.

If this were not the case, a bank would be better off borrowing all the funds it needed in the overnight cash market and rolling them over every day.

The reason banks borrow and lend at rates higher or lower than the average expected cash rate over the life of the loan is the need to allow for the various risks involved (the risk of not being repaid, the risk in agreeing to lend your money for a longer time, and so forth) and, of course, profit margins along the way.

For several years leading up to the global financial crisis, these various margins (known as "spreads" or "premia") didn't change much, meaning a change in the cash rate brought about an identical change in mortgage and other bank lending rates.

Since the crisis, however, margins have been changing a lot, as a result of people realising they weren't charging enough to cover the risks they were running, and our banks realising they needed more domestic, retail and longer-term funding to protect them against future crises, leading to intense competition between them to attract term deposits.

The net effect has been that the banks' borrowing costs have risen more (or fallen less) than the cash rate has, causing changes in, say, the mortgage rate, to be less generous than changes in the cash rate and thus widening the margin between the cash rate and the mortgage rate.

The Reserve has allowed for this shift in margins, cutting the cash rate by more than it would have so as to ensure market interest rates - the rates people actually pay - are where it wants them to be.

Its influence over market rates thus remains undiminished. And that's because the cash rate remains by far the most powerful influence over other interest rates - though, as we've seen, not the only influence.

Wednesday, July 18, 2012

Banks facing structural change, too

As I'm sure you've gathered, a surprising number of our industries are going through a painful, job-shifting process economists euphemistically refer to as "structural adjustment". You've heard at length about the tribulations of mining, manufacturing, tourism, retailing, aviation, bookselling, newspapers and free-to-air television.

Then there's all the angst and words spilt by the media, politicians and people with mortgages over structural change in banking. Huh?

When people have been carrying on about how the banks have stopped moving mortgage interest rates in line with changes in the Reserve Bank's official interest rate, they've actually been complaining about just one consequence of the structural change that's being imposed on banks around the world in reaction to the devastation wrought by the (continuing) global financial crisis.

Just how the banks are being forced to change was explained by the deputy governor of the Reserve Bank, Dr Philip Lowe, in a speech last week (on which I'll be drawing heavily).

All of us can remember the halcyon days before the financial crisis when mortgage interest rates moved in lock step with the official rate. Unfortunately, they were only halcyon on the surface. Underneath, big trouble was brewing.

Particularly in the United States and Europe, there was a lot of cheap money flowing around, so the banks got quite slapdash about whom they lent to. They lent at interest rates that were artificially low, failing to reflect the riskiness of the project and the chance they wouldn't get their money back.

They also greatly increased their "gearing" - the ratio of borrowed money to shareholders' capital they used to finance their activities. When business is booming, becoming more highly geared accelerates the rate at which your profits grow. When business turns down, however, it hastens the rate at which profits shrink and turn to losses.

As we know, the day of reckoning did come, many banks in the US and Europe got into deep trouble and had to be bailed out by their governments to prevent them collapsing and causing a depression. Even so, the North Atlantic economies dropped into deep recession, from which they've yet to properly emerge.

In the meantime, the bank regulators and the global financial markets are forcing the world's banks to change their ways and lift their game - in short, to operate more safely, reducing the risk of getting into difficulties. Although our banks are well regulated and didn't get into bother, they're still affected by this tightening up.

Banks are now required to hold a higher proportion of their funds in shareholders' capital and a higher proportion of their assets in liquid form, making it easier for them to cope with a surge in depositors wanting to withdraw their money.

The financial crisis made Australians realise how dependent our banks had become on using short-term overseas borrowings to meet the needs of local home and business borrowers. Before the crisis the interest rates our banks paid on these foreign borrowings were unrealistically low; now they're much higher, to adequately reflect the risks involved.

Our authorities, and our sharemarket, have been pressing the banks to do their overseas borrowing over longer periods and raise a higher proportion of their funds from local depositors.

Do these efforts to make our banks safer and more crisis-proof sound like a good thing? They are. But, like everything in the economy, they come at a price.

What banks do is act as intermediaries between savers on the one hand and borrowers on the other. The costs they incur in performing this invaluable service (including the return on the shareholders' money invested in their business) are called the "cost of intermediation", which is the gap between the average interest rate they charge on the money they lend out and the average interest rate they pay to depositors and other lenders.

The cost of making our banks safer - by requiring them to hold higher proportions of share capital and liquid assets - has raised the cost of intermediation. Most of this higher cost has been passed on to the banks' mortgage and business borrowers.

The higher cost of borrowing abroad and borrowing from local depositors has also been passed on.

This explains why, since the early days of the financial crisis, the banks have been raising mortgage rates by more (or cutting them by less) than movements in the official interest rate. Over the 10 years to 2007, the variable mortgage rate averaged 1.5 percentage points above the official rate. Today, it's about 2.7 percentage points above.

That's what all the complaints have been about. Now you know why it's happened. But this bad news has been accompanied by three bits of good news which have had far less attention.

First, much of the increase in mortgage rates is explained by the very much higher rates being paid to depositors as the banks compete furiously for our money. Before the financial crisis, deposit rates were well below the official rate; now they're above it (particularly on internet accounts). Depositors outnumber people with mortgages by two to one.

Second, safer banks mean people who invest in bank shares (which is everyone with superannuation) are running lower risks - meaning their profits don't need to be as high. The boss of Westpac, Gail Kelly, said recently its return on shareholders' equity had fallen from 23 per cent before the crisis to 15 per cent.

Finally, to reduce the pressure on bank borrowers caused by the banks' now higher margin above the official rate, the Reserve Bank has cut it by about 1.5 percentage points below what it would otherwise be.

Structural adjustment is always painful - but there's always someone who's left better off.

Saturday, October 8, 2011

Doomsday rate cut scenarios off mark

If the Reserve Bank ends up cutting the official interest rate by 0.25 percentage points on Melbourne Cup Day, it won't be because the economy has weakened so much as because it's not looking as strong - and thus, inflationary - as the Reserve had earlier expected.

The air is full of uncertainty and fear about the fate of the European and American economies, with one excitable pundit even predicting a ''world recession''. But, short of a major meltdown, the North Atlantic countries' troubles won't be a big part of the Reserve's reasons for fine-tuning the stance of its monetary (interest rate) policy.

No one knows what the future holds, and there's a ''non-trivial probability'', as the economists say, that the US economy will start contracting again and, more significantly, the problems in Greece will be so badly handled that the European economies implode.

Were that to happen, be in no doubt: the Reserve wouldn't just be lowering rates by one or two clicks, it would be slashing rates in much the way it did in the global financial crisis of 2008-09. But that's far from the authorities' ''central forecast''. They expect the US to grow by a bit under 2 per cent next year, while the euro area achieves no growth.

What would plunge Europe and the world back into crisis - with Europe entering a period of severe contraction - would be for Greece to leave the euro. That's because of the panic this would cause to euro depositors in many other member-countries.

It's likely the Europeans well understand what they need to do to avoid a conflagration: first, restructure the Greek government's debt (which means bond holders accepting big write-downs); second, recapitalise those European banks hard-hit by the write-down; third, have the European Central Bank purchase large quantities of European governments' bonds so as to lower bond yields and, hence, commercial interest rates.

So the Europeans' problem isn't knowing what to do, it's achieving the agreement of 17 squabbling member-countries to do it. The likeliest outcome is that they do enough to avert catastrophe, but not enough to prevent recurring episodes of financial-market jitters.

Our authorities' forecasts for 2012 aren't far from those the International Monetary Fund published last month. These have the US growing by 1.8 per cent and the euro area by 1.1 per cent. If so, that leaves the world economy growing by, what - 1.5 per cent? No, by 4 per cent - which is about the trend rate of growth. Huh?

What's missing from the sum is China's growth, expected to slow to a mere 9 per cent, and India's, to a paltry 7.5 per cent. Even Latin America is expected to grow by 4 per cent and sub-Saharan Africa by 5.8 per cent.

So much for a world recession.

Weakness in the North Atlantic doesn't equal weakness in Australia by a process of magic. You have to trace linkages between them and us. An important one is psychological: the effect of a sliding sharemarket, worrying news from the North Atlantic and over-excited talk of world recessions on the confidence of Australian consumers and business people.

As for ''real'' (tangible) linkages, these days the US and Europe aren't big export customers of ours. So the key question is the extent to which weakness in the North Atlantic leads to weakness in China, India and the rest of developing Asia.

These days, China is a lot less dependent on exports to the North Atlantic than it used to be. And the Chinese authorities have both the political imperative and the economic instruments needed to keep domestic demand growing fast enough to prevent much of a slowdown in production and employment growth.

So, barring a European implosion, the North Atlantic troubles' effect on us is likely to be limited mainly to their effect on confidence. If so, what are the domestic factors that could lead the Reserve to lower interest rates a little?

In May the Reserve was forecasting growth in 2011 of 4.25 per cent. In August it cut that to 3.25 per cent. Today it would probably say 3 per cent.

But get this: the overwhelming reason for these revisions is the temporary effect of the Queensland floods, in particular the loss of output from coalmines that are taking far longer than expected to resume production.

There have been various highly publicised areas of weakness in the domestic economy - the troubles our manufacturers are having coping with a high exchange rate, very weak department store sales and weak housing starts - but overall (and excluding extreme weather events), there's little sign of weakness.

Despite the much-publicised fall in

consumer confidence, consumer spending grew by 3.2 per cent over the year to June, bang on trend. Business investment has been strong and is sure to get stronger. And earlier figures showed worsening inflation and worryingly strong growth in labour costs per unit of production.

Indicators released this week show strong growth in exports and strengthening retail sales, home building approvals and non-residential building approvals.

The strongest evidence of weakening is in the labour market, with employment growth clearly slowing from its earlier fast past, and the unemployment rate jumping 0.4 percentage points to 5.3 per cent in just two months.

But this is a puzzle because, though growth in employment is weak, growth in hours worked isn't. And though surveyed unemployment is supposed to have jumped, the number of people on the dole is steady.

So how does the Reserve come to be contemplating lowering the official interest rate a little? Because its job is to keep interest rates at a level sufficient to keep inflation travelling within its 2 to 3 per cent target range, and the outlook for inflation has become less threatening.

For a start, the Bureau of Statistics has revised the underlying inflation rate over the year to June from 2.75 per cent to 2.5 per cent. Second, the outlook for economic growth isn't quite as strong as it had been. And third, the atmospherics of the labour market have improved, with more consumers worried about losing their jobs and employers less worried about the emergence of excessive wage demands.

The present stance of monetary policy is ''mildly restrictive''. But if the risk of inflation rising above the target range is now much reduced, the stance of policy should be returned to neutral. That would require a fall in the official rate of just one click - two at most.


Monday, July 25, 2011

Don't wish a fall in interest rates on us

So you like the sound of a cut in interest rates? Don't get your hopes up. It's possible, but not probable. And remember, rates go down only when times get tougher. Is that what you want?

Though the likelihood is that hysteria over the imminent devastation to be wrought by the carbon tax accounts for the greatest part of the present caution among consumers, vague anxiety over the incomprehensible goings on in Greece is probably also contributing.

I don't believe in troubling trouble until trouble troubles me - especially when there's nothing you can do about it. But it seems I'm in a minority. Scare yourself over some event that with any luck won't happen? Yeah, why not? Got to get some excitement in your life.

The surest way for us to get a cut in interest rates would be for some major disaster in Europe - say, a disorderly debt default by Greece that caused the flighty financial markets to spread contagion to other highly indebted members of the euro area - to bring about another global financial crisis.

Should it happen, it would be similar to what we experienced after the collapse of Lehman Brothers in September 2008, with one exception: the financial markets are less likely to freeze up the way they did then. This time, no bank, central bank or government could say they had no inkling it was coming - which is what reduces the likelihood of a disaster being allowed to happen.

What we would get is the same wave of fear and uncertainty among consumers and businesses sweeping instantaneously around the world to every country that has television news - even those with little direct connection to the debt problems, including China (as happened last time) and us (ditto). We wouldn't be human if we didn't act like sheep.

We now know what happens when consumers and businesses around the globe become uncertain about the future and so suspend any plans they may have had for new spending until the outlook becomes clearer: international trade plummets, industrial production dives and world commodity prices crash.

The first time that happened it didn't take the Reserve Bank long to figure out what it needed to do: slash interest rates. It cut the official interest rate by 4 percentage points in five months. It would take it even less time to come to a similar conclusion this time.

If you could enjoy some such huge cut in your mortgage rate while being completely sure you and yours would keep their jobs, what a wonderful world this would be for those schooled by politicians and the media to take an utterly self-centred view of the economy. Trouble is, with everyone around you panicking, you couldn't be at all sure of keeping your job.

But let's step back from the worst-case scenario to something more probable. The truth is that despite all the self-pitying, over-hyped gloom, the Reserve retains a ''bias to tighten'' - its expectation that sooner or later it will need to raise interest rates, not cut them.

Why? Because we're in the middle of the biggest commodity boom, and the early stages of the biggest mining construction boom, we've experienced in 140 years. And because it's delusional to imagine all the benefit from that boom is penned up in Western Australia.

To be more specific, it's because the Reserve's first responsibility is to keep inflation in check and inflation is showing signs of breaking out. In particular, wages are growing at the relatively fast rate of 4 per cent.

Were labour productivity improving at the 2 per cent or even 1.5 per cent rate we've enjoyed in the past, that would be nothing to worry about. But productivity improvement has been particularly limited for some years, meaning ''unit labour costs'' (the average cost of labour per unit of production) are rising at a rate that will add to employers' price pressure.

How do you slow down wages growth? By using an increase in interest rates to slow the growth in borrowing and spending - demand - and, hence, the derived demand for labour.

All this says the Reserve will be scrutinising the consumer price index figures we get on Wednesday with particular concern.

It's true, however, that significant parts of the economy are doing it tough at present. Some of this is the unavoidable and actually helpful consequence of the resources boom's effect on the dollar, but in the case of retailing it's a self-inflicted bout of caution.

So, despite its worries about inflation, the Reserve will be reluctant to raise interest rates while the weakness in retail sales and other parts of the economy raise a question about the ongoing strength of demand. If underlying inflation in the June quarter comes in at about 0.7 per cent, it will be happy to stay its hand and await a clearer picture. Were the underlying increase to be as high as 1 per cent, it would probably still avoid raising rates at its board meeting the following Tuesday, but would be most uncomfortable about it.

When will it raise rates? When it sees signs consumers are losing their caution, or if the unemployment rate were to keep falling.

But what would prompt it to cut rates in the absence of global catastrophe? A lower than expected rise in underlying inflation next week plus, over the next few months, continuing consumer caution leading to further weakness in economic activity and a significant rise in unemployment.

You may wish for a rise in joblessness to bring about a cut in your mortgage rate, but that would be selfish and quite possibly foolhardy.


Monday, November 29, 2010

Professed reformers spin lazy line on cost of living

Julia Gillard and her ministers are expressing their undying commitment to the economy and economic reform, but the way they pander to and even incite the punters' irrational whingeing about the cost of living gives the lie to their profession of economic faith.

For obvious reasons, the government has been saying a lot lately about Labor's values and vision for Australia. According to Gillard: "A strong economy - and opportunity for all. That's really it in a nutshell."

Wayne Swan said last week the Labor Party's "core purpose" had always started with two words: "prosperity and opportunity". (The more he said the clearer it became that, to him, Labor's reason for existence is solely materialistic: every worker should have the opportunity to own a Beemer.)

Penny Wong was a little broader in her view of what Labor stands for: "A fair go, a just society, a strong economy." (Note that none of the three saw fit to mention reconciling the economy with the environment as a priority.)

Get the message? Labor = a strong economy. So does this mean they're all economists or economic rationalists? No, it means they're politicians who've concluded that only good economic managers get to stay in office (and whose secret fear is that they aren't good economic managers).

They're pollies who've learnt to mind their economic P's and Q's - they know not to promise to control prices or re-regulate interest rates - but they haven't internalised "the economic way of thinking".

How can I be sure? Because of the way the politician in them leads them to pander to the public's complaints about the rising cost of living. And because anyone who thought like an economist wouldn't be able to resist the desire to explain to the whingers a few facts of life.

The punters are complaining about big rises in water and electricity prices. Do the pollies explain why these rises are occurring and why they're justified? Not that I've noticed. They just keep saying "I feel your pain".

Do they explain that, though water and power prices have increased a lot, other prices haven't risen much and some have actually fallen, meaning the overall cost of living hasn't been rising all that rapidly? Hell no.

The consumer price index rose by 2.8 per cent over the year to September. Over the previous year it rose by 1.3 per cent.

Behavioural economists understand how people develop exaggerated perceptions of what's happening to their cost of living. It's because people don't weight price rises according to the item's share in the basket of goods and services they buy.

Big price rises stick in their minds (with no allowance made for any improvement in the quality of the item), whereas small price falls are soon forgotten and items whose prices don't change get a weight of zero.

If economics is to be useful it should help people overcome their irrational misperceptions. But our self-proclaimed economic-reform obsessed leaders don't see a need to educate the electorate.

The obvious fact is the cost of living is always rising. That's not news. What matters is whether people's incomes are at least keeping up with the cost of living. And they are - easily. While consumer prices rose by 2.8 per cent over the year to September, the wage cost index rose by 3.6 per cent.

While prices rose by 1.3 per cent over the previous year, wages rose by 3.1 per cent. Over the five years to September, prices rose by 15.7 per cent, while wages rose by 20.8 per cent. So real wages have been rising by about 1 per cent a year.

It's because the cost of living is always rising that pensions are always being increased. They're actually indexed not to prices but to average income, meaning they grow in real terms. And last year the government gave pensioners (but not people on the dole) a big one-off increase.

So the rising cost of living is being outstripped by the rising standard of living. But still they whinge. And what do our piss-weak pollies say? "I feel your pain."

A pollie ought to understand that, because the cost of living is always rising, people complain about the cost of living when they haven't got anything more serious to complain about.

And what cause for complaint is there? Inflation is under control, employment has been growing very strongly, unemployment is a lot lower than we got used to, real wages are growing and the dollar's at parity with the greenback.

Do our pollies ever say any of this? Gosh no. Wouldn't dare.

Of course, interest rates are rising. And though far more people benefit from this than the one-third of households that have mortgages (many of them longstanding and thus quite small), the pollies compete to carry on about how iniquitous it is.

The government must think itself smart to have transferred the punters' ire from itself to the banks (aided by the carry-on of Joe Hockey). It knows the banks' double-dipping merely means one less official rate rise, but does it calm the punters with this news? Wouldn't dare.

When it comes to rate rises the government doesn't just feel your pain, it incites you to imagine it's the end of the world. This is smart? It's storing up trouble for the future.

Rate rises are the primary instrument we use to limit inflation pressure when the economy booms. And we're about to enter a mining construction boom that could run for a decade or more.

Do you reckon the strong-economy brigade has any notion of how many more rate rises we're likely to see before the next election?


Wednesday, September 29, 2010

Save before Reserve Bank forces you

Barring some global catastrophe, the outlook for our economy is particularly bright - so a lot of people aren't going to like it. Why not? Because of something many people have trouble getting their head around, the great paradox of macroeconomics: good things happen in bad times and bad things happen in good times.

We're looking at a long period in which a lot more people find jobs and part-timers get to work the longer hours they'd prefer, while wages grow faster than inflation and business booms.

There'll be just one fly in the ointment: the Reserve Bank will keep putting up interest rates. (Of course, this will be good news for people saving for retirement or already in it.)

Variable mortgage interest rates pivot around a long-term average rate of about 7.5 per cent. They're just under that at present, but either next Tuesday or on Melbourne Cup day it's a pretty safe bet they'll be moved up.

And that's likely to be just the first of a number of increases. Mortgage rates are likely to go well above 7.5 per cent and stay high for a considerable period - maybe until the next downturn in the economy.

In principle, economists love seeing the economy grow. In practice, they get nervous when it grows too fast, fearing that if our spending on goods and services (demand) grows faster than our production of goods and services (supply), all we'll get is higher inflation.

The resumption of the resources boom means our spending is likely to grow faster than production. That's because the world is paying sky-high prices for our exports of coal and iron ore, which is boosting our real incomes, and because mining, oil and gas companies are embarking on a massive investment program that may run for a decade.

What's that? You don't expect any of this mining income to come your way? It will come indirectly, in ways you haven't thought of. For a start, the federal government gets a 30 per cent cut of the miners' profits - and more once its new mining tax gets going in two years' time.

So the extra income may start out in Queensland and Western Australia, but it gets spread around. One way that happens is via the formula by which the proceeds from the GST are shared between the states. For years, NSW and Victoria got back a lot less than their citizens paid in GST and the smaller states benefited; now the two big states are getting a lot more back and the West Australians are coughing up (and, boy, aren't they complaining).

Another way is via the floating dollar. The value of our dollar tends to rise when the prices we're getting for our commodity exports are high. (And it rises a bit more when the financial markets are expecting rises in interest rates, as now.)

The higher dollar makes imported goods - and overseas holidays - cheaper and by this means part of the benefit of higher coal and iron ore prices is transferred from the miners to those people who buy imports, which is all of us.

So, yes, spending by Australian businesses and consumers is likely to grow faster than our production and, to the extent that spending doesn't just flow into imports, it will increase inflation pressure. But not to worry: the Reserve Bank has a tried and true method of slowing the growth in spending. It puts up interest rates, which tends to discourage those forms of spending that rely on borrowing.

Just how high rates will need to go remains to be seen. Many factors will affect it. One, within the collective control of ordinary Australians, is how much of our increased household income we choose to spend. We look to be entering an almost unprecedented boom in investment spending by business. Eventually, the extra mines, coal loaders and gas facilities will add to the nation's production capacity and our prosperity.

In the meantime, however, we don't have enough labour and other resources available to cope with a boom in physical investment and a boom in consumer spending at the same time. The higher interest rates will be particularly intended to discourage consumption and so leave room for investment.

But to the extent that you and I avoid spending all the extra income that comes our way, we'll limit the rise in interest rates intended to discourage us from spending. So now's a good time for us to be saving rather than spending.

That's another thing people have trouble understanding. Everything about our consumerist economy encourages us to spend. When politicians actually urge us to spend - as Kevin Rudd did last year at the time of the $900 cheques - it reinforces the (all too convenient) notion we have a patriotic duty to spend every cent we see.

In truth, the economy moves in cycles of boom and bust and the objective of the people attempting to manage it is to flatten out the peaks and troughs. To this end, they encourage ''counter-cyclical'' behaviour: in downturns, when no one wants to spend, they encourage spending; in booms, when everyone wants to spend, they encourage saving.

But whereas politicians like to give speeches portraying spending or saving as a moral imperative, econocrats have no room for morality in their model. They believe monetary incentives - nice or nasty - speak louder than words, and so merely reach for their interest-rate lever.

In recent times, households have been saving more of their income and doing so of their own volition. As a group, Australian households are heavily indebted - mainly on their homes - and the main way they've saved is by paying down their debts.

So it's a sensible thing to do and the longer we choose to keep doing it the less the Reserve will see a need to beat some parsimony into us with the stick of high interest rates.


Monday, September 27, 2010

How to limit looming interest rate rises

It's a pretty safe bet we'll get another rise in the official interest rate this year and several more next year.

A rise next Tuesday is possible, though the Reserve Bank board has a predilection for changing rates on Melbourne Cup day, after it has seen the quarterly consumer price index figures.

After the minutes of last month's board meeting and the speech the governor, Glenn Stevens, gave last week, there's not much doubt rates will be rising soon enough.

Why? Because the economy is already growing at trend (3.3 per cent over the year to June) with little spare capacity (the unemployment rate is down to 5.1 per cent), but the strength of job advertisements suggests further growth in employment is coming and the Reserve is expecting an acceleration to above-trend growth.

What's worrying the Reserve is that, whereas business investment spending has been flat (though at a remarkably high level relative to gross domestic product), the survey of firms' capital expenditure plans suggests it could grow by as much as 24 per cent in nominal terms next financial year, with mining accounting for most of that.

Although sky-high commodity prices will be feeding incomes and flowing into consumption, it's such huge rates of increase in physical investment that will make the resources boom so big and so potentially inflationary - ''the largest minerals and energy boom since the late 19th century'', according to Stevens.

Our history tells us it's investment booms and improvements in the terms of trade, rather than recessions, that pose the greatest challenges for macro-economic policy - mainly because mismanaged booms invariably lead to recessions.

Because booms are such pleasant things, in the past governments have tended to ignore the building inflation pressure until it can be ignored no longer. Then they panic, jam on the brakes, keep raising interest rates because they don't seem to be working and eventually the economy runs off the road and crashes, hurting passengers and bystanders alike.

Rest assured the Reserve won't be letting that happen this time. Having already returned the stance of monetary policy - the level of interest rates - to normal (or ''neutral'') levels, it will tighten further to keep the economy growing pretty much in line with the trend rate to prevent inflation pressures building up.

What's more, the Reserve will act pre-emptively, basing its moves on its forecast for inflation rather than waiting to see hard statistical proof a problem is building. (Actual inflation figures are important mainly because they're used to revise the forecasts.)

With the economy already so close to full capacity, we can be sure any forecast for growth much above trend, or for inflation heading up out of the target range, implies the need for higher rates, and higher rates will be forthcoming. One thing the economic managers have going for them in this boom rather than those of the past is the floating exchange rate. By floating up, it helps to limit the build-up of inflation pressure by redirecting some part of demand into the now-cheaper imports.

And by limiting demand for the products of non-mining export and import-competing industries - particularly manufacturing, education and tourism - it frees up labour and other resources to meet the ever-expanding needs of the minerals sector. This helps limit wage inflation.

Even so, if anything like the expected increase in investment spending occurs, rates have a fair way to go yet.

One thing that could limit the need for further rate rises is subdued consumer spending as households seek to get on top of their debts. Consumers take a breather, thus leaving more room for investment spending.

The ratio of household debt to disposable income has been steady for the past few years and it would be nice to see it falling over coming years. But how long it will take for the boom to overwhelm households' present restraint is anyone's guess. Mine is: not long.

Remember that, though it may not be long before commodity prices fall back from their present heights - while remaining high relative to their long-term trend - the investment phase of the boom could run and run, perhaps for a decade.

So, barring some global or China-centred catastrophe, it's reasonable to expect the exchange rate and interest rates to be uncomfortably high for many years to come. But is there anything the government could do to take some of the pressure off rates?

Without wishing to give comfort to the dishonest nonsense talked by the opposition - which implies that all interest rate rises (even those needed merely to return the official rate from the emergency lows achieved during the financial crisis) are the simple and direct consequence of the government's failure to slash its spending - there is something that could be done.

While the government will have its work cut out turning last financial year's $54.8 billion budget deficit into the now-promised surplus by 2012-13 - and this turnaround will exert a useful restraint on demand - the real challenge will come thereafter.

By all the ignorant logic of Costelloism, governments can ease up once the budget is back to surplus, granting tax cuts and allowing strong growth in spending - just as John Howard and Peter Costello did in the resources boom Part 1.

But just as this behaviour left the Reserve needing to raise interest rates somewhat more than would otherwise have been necessary, so Julia Gillard and Wayne Swan will face a similar choice. This, of course, is because tax cuts and increased spending add to private demand.

The answer is for Labor to continue its present strictures on tax cuts and spending, allowing the budget surplus to grow ever-bigger each year, something that could be readily justified to the mesmerised punters as needed to pay back our supposedly stupendous public debt.