Maybe Lowe should stay on as governor to clean up any spilt milk

I’ve never liked making free with the R-word until it’s an undeniable reality. Too many journalists refuse to recognise that if enough people in positions of influence predict bad things enough times, their predictions have a tendency to become reality.

But I confess I’m starting to worry that Reserve Bank governor Dr Philip Lowe – a man who, until now, I’ve always regarded as having steady judgment – is pressing harder on the interest-rate brakes than he needs to. And I don’t think I’m the only economy-watcher who shares that fear.

He seems to be seizing on any argument that says he should give the thumbscrews another turn, while ignoring all the arguments that say he’s already done enough. The Fair Work Commission has awarded the people whose wages constitute the bottom 10th of the national wage bill a 5.75 per cent pay rise. Oh, no! Give it another turn.

Employment grew by 76,000 in May and the unemployment rate went down a fraction. Oh, no! Give it another turn.

One of the rules of using interest rates to suppress demand is that they work with “long and variable lags” so that, if you keep tightening until it’s clear you’ve done enough, you’ve already done too much and will crash the economy. But Lowe seems to have forgotten this.

Another thing he seems to have forgotten is that, in times past, we’ve needed a big increase in interest rates to slow a booming economy because the boom has resulted in real wages growing so strongly.

Not this time. This time an unusual feature of the boom has been that real wages have been falling for several years. Do you realise that real labour costs per unit of production are now 6 per cent lower than they were at the end of 2019?

What’s been (conveniently) forgotten is that, in the early days of the pandemic, when we imagined we were in for a severe recession, employers were quick to demand a wage freeze, to which workers readily acquiesced.

Turned out that a couple of lockdowns don’t equal a recession, and employers did fine. But there was no suggestion of a catch-up for the wage freeze that wasn’t needed. Remember this next time you see Lowe banging on about the worrying rise in nominal labour costs per unit.

If Lowe knew more about how wages are fixed in the real world, rather than in economics textbooks, he’d have noticed that the union movement’s failure to talk about the need for a wage catch-up was a sign of its diminished bargaining power.

(He’d also be more conscious that the conventional economic model’s implicit assumption – that the parties to every transaction are of roughly equal bargaining power – doesn’t hold between an employer and an employee. Nor between a big business and a small business, for that matter.)

Then there’s Lowe’s invention of a new doctrine (one previously exclusive to bull-dusting employer groups) that workers need to produce more if they want their wages merely to keep up with inflation.

Lowe professes to be terribly worried about a fall in the productivity of labour in recent quarters but, as The Conversation website’s Peter Martin has reminded us, falling productivity (output per hour worked) is exactly what you’d expect to see at a time when falling unemployment is returning us to full employment.

Employers have preferred to hire more workers rather than buy more labour-saving machines. And, as the econocrats have pointed out, they’re having to hire more of the kinds of workers they usually prefer not to hire – the young, the old and the long-term unemployed.

That is, they’ve had to start hiring the less-productive. This is a bad thing, is it?

One reason I’m shocked by Lowe’s newly invented line that, absent productivity improvement, all wage growth above 2.5 per cent is inflationary, is that I was around in the 1970s when wage growth really was excessive and inflationary. It was to be condemned then; but anyone saying it now has moved the goal posts.

It was then that Treasury made so much fuss about labour costs per unit that the Bureau of Statistics began publishing the figures every quarter – the ones Lowe has been leaning on so heavily.

But when the Australia Institute think tank copied the method used by the European Central Bank (and now by the Organisation for Economic Co-operation and Development) to calculate profits per unit, the econocrats wrote learned treatises saying its method was “flawed”. Apparently, sauce for the wages goose is not sauce for the profits gander.

Speaking of flaws, the flaw in Lowe’s new-found argument that wage rises exceeding 2.5 per cent, but less than the rise in prices, are inflationary ought to be obvious to anyone not blinded by pro-business bias. It doesn’t add to the inflation rate, but it does add to the time it takes for the inflation rate to fall back.

So, what Lowe’s on about is the speed at which inflation is returning to (the now unrealistically low) target range of 2 to 3 per cent. And he’s in such a tearing hurry he’s prepared to risk causing a recession.

Why? Well, what I wonder is whether Lowe’s expectation that his term as governor won’t be renewed in September – so a new governor can make the changes the Reserve Bank review has recommended – is affecting his judgment.

There’s a concept in economics called “revealed preference” which says: judge people not by what they say, but what they do. Lowe says he’s aiming for the “narrow path” to low inflation without a recession.

But what he seems to be aiming for is low inflation come hell or high water. I wonder if he’s decided he prefers not to be remembered as the governor who let inflation get out of control, but left without fixing it.

If, to avoid that fate, he has to be remembered as the guy who plunged the economy into a recession no one thought was needed, then them’s the breaks.

The sad truth about independent central banks is that, if they really stuff up, it’s the elected government that gets blamed. Since there’s no voting for who’s to be governor, there’s no other way voters can register their disaffection.

So, if Lowe continues finding excuses to tighten the monetary screws, don’t be surprised if the Albanese government gets ever less muted in its criticism.

But if I were Treasurer Jim Chalmers, I’d consider postponing the reform of the Reserve’s procedures and extending Lowe’s term, so his mind could be fully focused on achieving the soft landing – or be around to share the blame if he crashes the plane. And help mop up the debris if he fails. This may also stop him acting so uncharacteristically.

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RBA review attacks the groupthink of others, but not its own

With more time to think about it, it’s clear the review of the Reserve Bank is not the sweeping blockbuster shake-up overhaul we were told it was. Even if all its recommendations are accepted, ordinary borrowers and savers won’t discern any difference in the way interest rates go up and down. But to those who work at the Reserve, and the small army of people who make a lucrative living second-guessing its decisions, the proposed “modest improvements” are a big deal.

Ostensibly, they’re aimed at getting the Reserve up to “world best practice”. But that’s just a spin doctor’s term for doing things the same way everyone else does them. Where’s the evidence that the conventional wisdom is sure to be “best practice”?

It’s also a way of concealing the colonial cringe. Because the rich world’s financial markets are now so highly integrated, with the biggest rich country’s Wall Street setting the lead, most people in our financial market think that if we’re not doing it the way the US Federal Reserve does it, we’re obviously doing it wrong.

This inferiority complex is reinforced because, for the past 30 years, most other central banks have conformed to the US Fed’s ways – even the world’s best colony-conscious country, Britain, has switched to the Fed’s way.

So, what is the Fed’s way? To have interest rates set by a special committee of outside experts, meeting eight times a year not monthly, with each member employed part-time and getting lots of research assistance.

The monetary policy committee should hold a press conference after every meeting and each member should give at least one speech a year on the topic.

To be fair, the Reserve’s Americanisation was pre-ordained by Treasurer Jim Chalmers’ terms of reference and his decision to have the inquiry led by Carolyn Wilkins, a former Bank of Canada heavy and now Bank of England heavy.

Of course, just because we do things differently to the others doesn’t guarantee we’re doing it better, any more than it means we’ve been doing it worse. I’d say our performance over the past 30 years – since the introduction of inflation targeting – has seen a few missteps, but been at least as good as any of the others.

And if the American way is “best practice”, how come the Fed’s been so heavily criticised for being slow to respond to the inflation surge?

But let’s be frank. The review’s big criticism of the Reserve is that it’s too insular, too inward looking and inbred. Except when one Treasury man got the job, governors are always promoted internally. The present governor joined the bank from high school. External appointments to senior economic jobs are rare.

As the review’s critique implies, the Reserve is a one-man band. The governor’s word is law, with limited tolerance for debate. He runs as much of the show as he chooses to, leaving the boring bits to his deputy.

It suits the governor to have a board stacked with business people because, not being economists, their doubts are easily dismissed. Employees would never disagree with the boss in front of the board, and any reservations the Treasury secretary may have would be raised in private.

There always used to be a union leader on the board, but he was let go as part of John Howard’s efforts to delegitimise the union movement which, in his eyes, was in league with his Labor opponents.

This does much to explain the present governor’s ignorance of labour-market realities. Dr Philip Lowe bangs on unceasingly about wages, but excludes unions from the Reserve’s extensive consultations with business and even welfare groups. I don’t remember hearing that swearword “union” ever pass his lips.

There’s always been an academic economist on the board, but they’re in no position seriously to take on the establishment. The board rarely if ever votes on anything. Rather, the chairman-governor “sums up the feeling of the meeting”.

Note, the Reserve has worked this way for the four decades I’ve been watching it. But it does seem to have become more insular and, as the review charges, more subject to “groupthink”, under Lowe.

The inquiry heard from young ex-Reserve economists saying they’d been warned that expressing doubt about the house line would harm their promotion prospects. I’ve been hearing that lately, too.

It’s madness for the Reserve to recruit the cream of each year’s graduating economists, then tell ’em not to speak unless spoken to. And what a way to train the next governor but three.

So, bring an end to groupthink inside the Reserve? Of course. Get a more vigorous debate around the board table before deciding on rates? Sure.

But here’s the joke. While rightly criticising the Reserve for encouraging groupthink, the report is itself a giant case of groupthink. It accepts unquestioningly the conventional wisdom of recent decades that there’s really only one way you could possibly manage the economy through the ups and downs of the business cycle, and that’s by manipulating interest rates.

Any role for “fiscal policy” – changing taxes and government spending? Didn’t think of that but, no, not really. Just make sure it doesn’t get in the way of the central bank.

We’ve fiddled with interest rates so much we’ve got them down to zero. Should we stop? Gosh no. Just think of some way to keep going. The review accepts that the central banks’ misadventure into “unconventional monetary policy” – UMP – which it sanctifies as “additional monetary policy tools”, is now part of “best practice”.

Really? Competitive currency devaluations are the way to fix the global economy’s ills? Can you hear yourselves?

Apparently, slowing the growth in spending by directly punishing the small proportion of households young and foolish enough to load themselves up with mortgage debt is “best practice”.

No, it’s not. It’s just a sign that the review committee is so caught up by global groupthink that it has never thought there might be a better way.

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Central banking: don't mention business pricing power

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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It's no wonder the young hate Boomers like me

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Why interest rates are going up, and won't be coming down

It’s time we had a serious talk about interest rates. And, while we’re at it, inflation. Someone in my job knows it’s time to talk turkey when the man in charge of rates, Reserve Bank governor Dr Philip Lowe, decides to go on the ABC’s 7.30 program to talk about both.

There’s much to talk about. Why are interest rates of such interest to so many (sorry)? Why do some people hate them going up and some love it? How do interest rates and the inflation rate fit together? Why do central banks such as our Reserve keep moving them up and down? When rates go up, they normally come back down – so why won't that happen this time?

Starting with the basics, interest is the price or fee that someone who wants to borrow money for a period has to pay to someone who has money they’re prepared to lend – for a fee.

Legally, the “person” you’ve borrowed from is usually a bank, while the person with savings to lend deposits them with a bank. But economists see banks as just “intermediaries” that bring borrowers on one side together with ordinary savers on the other.

The bank charges borrowers a higher interest rate than it pays its depositors. The difference reflects the bank’s reward for bringing the two sides together, but also the risk the bank is running that the borrower won’t repay the debt, leaving the bank liable to repay the depositor.

You see from this that interest is an expense to borrowers, but income to savers. This is why there’s so much arguing over interest rates. Borrowers hate to see them rise, but savers hate to see them fall. (The media conceal this two-sided relationship by almost always treating rate rises as bad.)

Now we get to inflation. Economists think of interest rates as having two components. The first is the compensation that the borrower must pay the saver for the loss in the purchasing power of their money while it’s in the borrower’s hands. The second part is the “real” or after-inflation interest rate that the borrower must pay the saver for giving up the use of their own money for a period.

This implies that the level of interest rates should roughly rise and fall in line with the ups and downs in the rate of inflation – the annual rate at which the prices consumers pay for goods and services (but not for assets such as shares or houses) are rising.

This explains why, when the inflation rate was way above 5 per cent throughout the 1970s and ’80s, interest rates were far higher than they’ve been since.

Now it gets tricky. Central banks have the ability to control variable interest rates by manipulating what’s known confusingly as the “overnight cash rate”. This “official” interest rate forms the base for all the other (higher) interest rates we pay or receive.

The Reserve Bank uses its control over this base interest rate to smooth the ups and downs in the economy, trying to keep both inflation and unemployment low.

When it thinks our demand for goods and services is too weak and is worsening unemployment, it cuts interest rates to encourage borrowing and spending. When it thinks our demand is too strong and is worsening inflation, it raises interest rates to discourage borrowing and spending.

The pandemic and the consequent “coronacession” caused the Reserve (and all the other rich-country central banks) to cut the official interest rate almost to zero.

The economy has bounced back from the lockdowns and is now growing strongly, with very low unemployment and many vacant jobs. But now we’ve been hit by big price rises from overseas, the result of supply bottlenecks caused by the pandemic and a leap in oil and gas prices caused by the war on Ukraine, plus the effect of climate change on local meat and vegetable prices.

As Lowe explained to Leigh Sales on 7.30, these are once-only price rises and, although he expects the inflation rate to reach 7 per cent by the end of this year, it should then start falling back toward the Reserve’s target inflation rate of 2 to 3 per cent.

His worry is that the economy’s capacity to produce all the goods and services being demanded is close to running out – and already has in housing and construction. This raises the risk that the rate of growth in prices won’t fall back as soon as it should.

This is why Lowe’s started raising the official interest rate from its pandemic “emergency setting” near zero – zero! – to a “more normal setting”. Such as? To more like 2.5 per cent, he told Sales.

Why 2.5 per cent? Because that’s the mid-point of his inflation target.

Get it? Interest rates are supposed to cover expected inflation plus a bit more. Once Lowe’s able to get them back up to that level without causing a recession, they won’t be coming back down until the next pandemic-sized emergency.

A base interest rate of zero was never going to be the new normal. The nation’s saving grandparents would never cop it.

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Interest rates definitely to rise - sometime, maybe

The geniuses in the financial markets – and they must be geniuses because they’re paid far more than we are – think next year will be an absolute ripper. Workers will be getting their first decent pay rise in six years or more. Say, 3 to 4 per cent. Whoopee. Gee, thanks guys.

Find that hard to believe? So do I. It’s the logical implication of the bets they’re making that the Reserve Bank will begin lifting its official interest rate – which has been at almost zero for a year – by the middle of next year and be up to 1 or 1.25 per cent by the end of next year.

For that to happen, the underlying or core rate of inflation, which has been below the bottom of the Reserve’s 2 to 3 per cent target for years and only just a few weeks ago lifted its head to 2.1 per cent, would need to have shot up close to 3 per cent.

And, because the inflation rate doesn’t rise sustainably unless it’s being driven up by rising wages, an inflation rate approaching 3 per cent couldn’t happen without annual pay rises averaging 3 to 4 per cent.

Reserve Bank governor Dr Philip Lowe has spelt out this relationship between inflation, wages and interest rates almost every time he’s opened his mouth since even before the arrival of the pandemic. He did so again twice last Tuesday and once on Friday.

So pay rises of unheard-of size are the logical implication of the money market’s bets that the Reserve is about to become so desperately worried about soaring wages that it will have raised the official interest rate four or five times in the next 12 months.

Trouble is, I doubt the financial market players are thinking logically. I doubt they’ve thought it through to the extent I just described. The economists who work in the financial markets are well-educated, but this episode makes me wonder whether the guys laying bets in the dealing room even have wages in their mental model of what drives inflation and interest rates.

By the way, I’m not just being disparaging in describing the financial markets as a casino. As Professor John Kay explained in his book Other People’s Money, the buying and selling of currencies, bonds and other real and derivative securities each day in the world’s financial market dwarfs the number of transactions needed by real businesses to conduct their ordinary affairs.

Indeed, Kay told me those genuinely necessary transactions could be put through in about a quarter of an hour a week. So, what are all the remaining transactions? They’re dealers using their bank’s money to trade with dealers from other banks in the hope of making a quick million or two and a fat bonus at the end of the year.

I’m sure these professional gamblers are better at playing poker than you or I would be, but they aren’t trained economists, and they don’t think like economists. Certainly, not like central bank governors.

Because Wall Street has the greatest single influence over what happens in the global financial markets, these guys know more about what’s happening – and likely to happen – in the American economy than their own.

They also have a huge superficial knowledge of what’s been happening in lots of economies in the past few weeks. They know inflation has shot up in the US, Britain and a few other countries, wages have increased somewhat in the US and a few other places, and some minor central banks have started raising their official interest rates.

I think these guys’ mental model of what’s driving interest rates is no more profound than this: prices and wages are rising in the US and other places, rates are already rising around the world, so pretty soon rates will be rising here.

Lowe, the man with his hand on the lever, says he still doesn’t think a rate rise will be needed until 2024, but last week he admitted things could turn out stronger than he expects and make a rise necessary in 2023.

There you are. He’s as good as admitted he’ll have no choice but to start raising rates in a few months’ time. Anyway, that’s what we’re betting on. If we turn out to be wrong, it wouldn’t be the first time, and we won’t lose our jobs. We’ll just lay new bets and keep doing it until we’re right.

Which they will be – one day. Since rates can’t go lower it’s a cert that the next move will be up. Right now, when they’ll be going up is known only to God. In the absence of inside intel, I’d rather put my money on Lowe than on those geniuses.

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Don't believe the boys who cry 'interest rates to rise'

Heard the talk that a rise in interest rates is getting closer? So’s Christmas. Here’s my advice: the greatest likelihood is that a rise is still years away. But between now and then you’ll keep hearing stories that it’s on the way. Ignore them.

Why? Because though nature abhors a vacuum, it doesn’t do so as much as the financial markets and the financial media do. They form an unholy alliance because both make their living speculating about changes in interest rates.

They cannot abide a situation where rates don’t change for years on end. So they keep trying to convince themselves something’s about to happen. The financial markets jump at shadows and, whenever they do, the media breathlessly report this worrying development.

The plain truth is, no one knows what the future holds – not even me. But all of us crave to know what’s coming, and keep searching for the person who may be able to tell us. The traders in the financial markets – who do infinitely more buying and selling of securities and currencies than is required to meet the needs of their business customers – earn a well-buttered crust by betting with each other on what’s coming down the pipe.

The media make their living partly by catering to their customers’ unquenchable curiosity about the future. Any interesting opinion will do, though they know that bad news sells better than good. A rise in rates would be bad news for people with mortgages, but good news for people living on their savings in retirement. But the people who choose what news we’re told about can’t imagine they’ll be old themselves one day.

Although no one but God knows for certain what will happen to interest rates, you’d think the person likely to be best informed on the subject is the person with most influence over interest rates in Australia, the boss of our central bank, Reserve Bank governor Dr Philip Lowe.

For more than a year, Lowe has kept telling us – and the markets – that the Reserve is “unlikely” to raise the official interest rate “until 2024 at the earliest”. But there was much excitement last week when he changed this to saying the Reserve’s “central scenario” is that a rise won’t be needed “before 2024″ – that is, not for another two and a half to three years.

What this means is that, whereas it couldn’t see any likelihood a rise would be needed until 2025, it can now see a “range of plausible scenarios” where “further positive surprises” could make a rise appropriate some time during 2024.

The further surprises would mean that annual growth in wages exceed 3 per cent earlier that in the Reserve’s “central scenario”. Although its target is annual inflation of 2 to 3 per cent, and its statutory duty is to achieve full employment (something it now sees as necessary to get inflation back up into the target zone), wage growth of 3 per cent-plus is a key indicator because “history teaches that sustained [my emphasis] changes to the inflation rate are accompanied by sustained [ditto] changes in growth in labour costs”.

Our annual rate of wage growth hasn’t exceeded 3 per cent since March 2013 – more than eight years ago, long before the pandemic – so you see why the Reserve’s “central scenario” is that getting back to it is likely to take several years yet.

For much of this year, however, the financial markets have thought they knew better that the Reserve governor. And nothing he said last week persuaded them he might know more about his likely decisions than they did.

There was little change in futures market prices showing they expect a rate rise in a year’s time – July 2022 – and another in the first half of 2023.

Why do the markets think they know better? Well, because the world’s national financial markets are now so highly integrated, traders probably spend more time thinking about the global market leader, the US economy and Wall Street, than they do about our economy. And they’re always tempted to follow a simple decision rule: whatever the US Federal Reserve is doing, we’ll be doing soon enough.

They may be right in believing rising inflation pressures in the US will lead the Fed to start raising interest rates sooner than sometime in 2024 at the earliest. But what they miss is the big differences between our circumstances and the Yanks’ when it comes to prices and wages.

None of the advanced economies were roaring ahead before the arrival of the pandemic, but the US was travelling a lot faster than we were. So we have a lot more ground to make up than they do. Although most advanced economies have long had inflation rates below their central banks’ target range, ours has been a lot further below than the Americans’.

That’s probably because, over recent years, their market for labour has been a lot “tighter” than ours. Their rate of wage growth has been much less weak than ours has.

A big reason for this is that, in our labour market, the increased demand for workers has been more closely matched by an increase in the supply of workers, whereas theirs hasn’t been. Our rate of working-age people already participating in the labour force has risen to near-record highs, whereas theirs has been much lower.

A lot of the increase in our supply of labour has come from our relatively higher levels of immigration. This has ceased to be true since we closed our borders – which does a lot to explain why employment and unemployment have bounced back to their pre-pandemic levels much earlier than we were expecting – so one of Lowe’s uncertainties is how long this strange form of stimulus will last.

The American financial markets began worrying about the risk of rising inflation earlier this year. This is partly because President Biden has been applying huge amounts of budgetary stimulus, and because of rising commodity prices and reports of shortages of the supply of semiconductors and other things, caused by the pandemic’s disruption.

By contrast, our government is busy ending its big stimulus programs. And supply shortages are temporary. Increases in prices don’t become a lasting increase in the rate of inflation unless they lead to higher wages. That’s what Lowe means when he stresses that he won’t be putting up interest rates until enough time has passed to convince him the increases in inflation and wages are “sustained”.

The final thing to remember is that one reason the financial markets are so quick to jump to conclusions about what lies ahead is that, because they lay new bets every day, they know they can jump to a different conclusion in a few weeks’ time. To them, it’s all part of the fun of being a professional gambler.

If you actually enjoy worrying that interest rates may rise – all the thrills and spills along the way – then be the media’s guest. But if you have better things to do and just want a credible view about the future that doesn’t change any more often than it has to, feel free to ignore the markets’ fun and games.

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Lowe should rescue a PM lost in the Canberra bubble

Dr Philip Lowe, governor of the Reserve Bank, is one of the smartest economists in the land. You don’t get a PhD from the Massachusetts Institute of Technology unless you’re super-sharp. But the question now is whether he has the courage to stand up to a wilful Prime Minister whose confidence far exceeds his comprehension.

Scott Morrison, as we know, is refusing to do what Lowe – with the support of the international agencies and most of our economists – has been begging him to do: use his budget to come to the rescue of monetary policy and its ever-feebler efforts to stop the economy slowing almost to stalling-speed.

Morrison is desperate to deliver a budget surplus. So desperate he’s convinced himself that failing to do so would cost him more political support than would allowing the economy to continue failing to lift voters’ living standards, and be so weak that a shock from abroad could push us into recession.

How any politician could come to such a self-harming conclusion is hard to fathom. Perhaps it’s that the 28 years since our last severe recession have robbed the latest generation of Liberal pollies of their economic nous.

Morrison’s so green he hasn’t learnt the first rule of politics: if you stuff up the economy, they throw you out. If that’s news to you, remember the 1961 credit squeeze, which brought Bob Menzies within a whisker of having his career cut short.

Remember how the 1975 recession dispatched with Gough Whitlam, the recession of the early 1980s finished Malcolm Fraser and the 1990 recession caught up with Paul Keating despite a one-term reprieve granted by Liberal fumbling of the 1993 election.

The question for Lowe is how he responds to the Prime Minister’s misreading of his own best interests (not to mention ours). Does Lowe stand back and watch an overconfident leader dice with political death by pretending that monetary policy hasn’t reached the end of its useful life and that blood can still be squeezed from the stone? Or does he announce he’s done all he sensibly can and turn the economy’s problem back to the one (elected) person who could fix it if he came to his senses?

Conventional monetary policy (interest-rate manipulation) has lost most of its power because household debt is at record levels, because the official interest rate is almost at zero, and because rates are already so low that another few cuts won’t make much difference.

Further, as Lowe explained in his speech last week, there’s little to be gained from deciding to progress to QE – "quantitative easing". It’s not capable of lowering rates much further and, in any case, comes at a cost.

As Lowe himself has acknowledged, it creates a moral hazard. For as long as Lowe pretends monetary policy is still effective, he’s running cover for the person who could do something effective, but chooses not to.

And it’s not just the absence of a positive, it’s also the continuation of a negative. Everything that causes the budget to take more out of the economy than it puts back in government spending causes private demand to be weaker.

Consider the way continuing bracket creep (only partly countered by the new middle income-earners’ tax offset) takes a bigger bite out of households’ wage income before they can spend it. Fiscal policy is actually counteracting monetary policy.

In his speech outlining the "limitations of monetary policy" and his lack of enthusiasm for unconventional measures, Lowe noted that their modest benefits needed to be balanced against their possible adverse side-effects.

Such as? First, they may change incentives in an unhelpful way. Providing the banks with ready liquidity during emergencies may encourage them not to bother holding their own adequate buffers, thus making further crises more likely.

Similarly, "the willingness of a central bank to use its full range of policy instruments might create an inaction bias by other policymakers [and] this could lead to an over-reliance on monetary policy," he said. But which policymakers could he possibly have in mind?

A second possible side effect is reducing the efficiency with which resources are allocated throughout the economy. Low interest rates and flattening the yield curve (pushing long-term interest rates down to the level of short-term rates) can damage banks’ profitability, leaving them with less capacity to lend.

There are also risks to the stability of the financial system when low interest rates cause the prices of property or shares (and borrowing) to boom at a time when the economy’s actually weak.

Finally, a third side-effect is a blurring of the lines between monetary policy and fiscal policy. "If the central bank is buying large amounts of government debt at zero interest rates, this could be seen as money-financed government spending," and so damage a country’s credibility internationally.

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QE: not certain, not soon, no great help, no let-out for govt

The big economic development this week was Reserve Bank governor Dr Philip Lowe giving the financial markets’ expectations about QE – “quantitative easing” - and other unconventional monetary policy an almighty hosing down.

In his speech on Tuesday he disabused the financial markets of the notion that, as soon as the Reserve had cut the official interest rate to zero, it would be on with QE and business as unusual.

Equally, he disabused our surplus-fixated government of any notion that his resort to unconventional monetary policy (manipulation of interest rates) would relieve it of the need to use conventional fiscal policy (budget measures) to get the economy moving again.

Lowe’s first act was to pooh-pooh most of the unconventional policies the letters QE conjure up in the minds of excitable market players. He identified four possible tools and rejected two and a half of them.

Let’s start with “forward guidance” – the notion of the central bank seeking to improve the confidence of consumers and firms by making its intentions on interest rates unmistakably clear. Great idea, he said, which is why he’d be doing it for ages and would keep doing it. Interest rates, he said, “will remain low for an extended period”.

Second is “extended liquidity operations”. During the global financial crisis in 2008, many central banks made significant changes to their usual ways of dealing with banks.

This was when financial markets were so disrupted that banks were too worried about their own finances to want to keep lending to ordinary businesses, threatening to crunch the economy.

Central banks dramatically increased their lending to banks, lent against the security of assets other than government bonds, lent for longer periods and lent at discounted rates of interest.

That is, they did what anyone with any sense would do to calm a crisis. Most of these extraordinary arrangements were soon unwound after calm had been restored. The Reserve itself had done some of them.

Would it do the same again should another crisis occur? Of course. At present, however, everything was working normally and our banks were able borrow as much as they needed – here or from abroad - at reasonable interest rates. So forget that one.

The third unconventional measure Lowe listed was “negative interest rates”. We used to assume that interest rates couldn’t go below zero, but things have become so desperate in Japan and then Europe – but nowhere else – that central banks have started paying banks negative interest rates. Governments have issued bonds at negative yields. That is, the borrower doesn’t pay the lender, the lender pays the borrower.

“Unconventional” doesn’t do justice to such a topsy-turvy world. It was long assumed that if banks started charging people to deposit their money, most of them would keep their money in cash under the bed. Lowe says there’s been a bit of that, but not much.

Why not? Partly because the negative rates are tiny – minus 0.5 per cent in the euro area, minus 0.1 per cent in Japan. But mainly because the negative rates have been restricted to charging banks and bond holders. No one’s been mad enough to try it on ordinary businesses or households.

So what are the chances we’d see negative rates here? It’s “extraordinary unlikely”, according to Lowe.

Which brings us finally to “asset purchases”. This is the only one of the four unconventional tools that can be called QE – quantitative easing. The central bank buys financial assets – securities – from the banks, paying for them merely by crediting the banks’ deposit accounts with the central bank.

This adds to the central bank’s liabilities, and to its holdings of financial assets, thus expanding its balance sheet and increasing the supply of money. Many central banks have purchased huge amounts of securities since the financial crisis, the vast majority of them being government bonds.

So, what’s Lowe’s attitude to QE? Well, for openers, he has “no appetite” for buying private sector securities (that’s the half I mentioned). But “if – and it is important to emphasise the word if – the Reserve Bank were to undertake a program of quantitative easing, we would purchase government bonds, and we would do so in the secondary [second-hand] market”. That is, it wouldn’t buy bonds newly issued by the government.

It would do QE because government bonds are assumed to be risk-free, and adding to the demand for bonds would lower the risk-free interest rate – not just for bonds but for all borrowing, from short-term to long-term. This should encourage borrowing and spending, as well as making our industries more price-competitive internationally by further lowering our dollar.

Whoopee-do. The financial markets ride again and monetary policy rolls on, allowing the government to continue putting the state of the budget ahead of the state of the economy.

Not so fast. Lowe said he wouldn’t even start to wonder about QE until we reached the point where the official interest rate had been lowered to 0.25 per cent (which would be as low as it’s possible to go).

And get this: “the threshold for undertaking QE in Australia has not been reached, and I don’t expect it to be reached in the near future.”

But his “threshold” isn’t the official rate down to 0.25 per cent. It’s trickier. “There is not a smooth continuum running from interest rate reductions to quantitative easing. It is a bigger step to engage in money-financed asset purchases by the central bank than it is to cut interest rates.

“In considering the case for QE, we would need to balance [the] positive effects with possible [adverse] side-effects.” Oh, didn’t think of those. He implied that he wouldn’t move to QE unless he was convinced we’d begun moving away from the inflation target and full employment.

Finally, having said the official interest rate couldn’t be cut below 0.25 per cent, he then estimated the scope for using QE to lower interest rates was no more than 0.2 percentage points. Sound like a magic wand to you?

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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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Boards and managers responsible for reducing banks' value

Too few of us realise it, but we should thank God (and my new best friend, Peter Costello) for our independent central bank. Prime ministers and treasurers seem to say little that’s not point scoring, and Treasury is now highly politicised, but we can always rely on Reserve Bank governors to be frank about what’s happening in the economy and what should be happening.

Last week the latest of our straight-shooting governors, Dr Philip Lowe, offered his conclusions on the shocking revelations of the banking royal commission. His wise words are worth recounting at length, to be sure you don’t miss them.

As Lowe reminds us, finance is all about trust. The first line of the voluntary “banking and finance oath” (which more bankers should now be taking) says “trust is the foundation of my profession”.

Australian banks have a strong record of being worthy of the trust that is placed in them to repay deposits, but in other areas trust has been strained.

The royal commission has highlighted three issues where work is needed to restore the public’s trust. First, Lowe says, “the inadequate way in which banks have dealt with conflict of interest issues”.

Second, “the way that poorly designed incentive systems can distort behaviour – promoting a sales culture at the expense of a service culture, and promoting the short term at the expense of the long term”.

Third, “the fact that the consequences for not doing the right thing have, in some cases, been too light”.

Central to fixing these breaches of trust is creating a strong culture of service within our financial institutions, Lowe says. This starts with correcting the system of internal reward established by the board and management.

“The vast bulk of the people who work for Australia’s financial institutions do want to do the right thing, and they do want to serve their customers as best they can. But, like everybody else, they respond to the incentives they face.

“If they are rewarded on sales or short-term objectives, it should not come as a great surprise that that’s what they prioritise.”

In the minds of economists, incentives can be negative (sticks) as well as positive (carrots). “One of the things that influences incentives is the consequences and penalties that apply when something goes wrong.

“Strong penalties can play an important role in incentivising good behaviour, and this is an area we should be looking it.”

But it’s worth distinguishing between the penalties that apply for poor conduct and those that apply for granting loans that can’t be repaid, Lowe says. “On conduct issues, we should set our expectations and standards high, and if they are not met the penalties should be firm.”

With bank lending, however, it’s trickier. “Even when banks lend responsibly, a percentage of borrowers will end up in financial strife and be unable to meet their obligations.

“We need banks to be prepared to make loans in the full expectation that some borrowers will not be able to pay them back."

Get this: “Banks need to take risk and manage that risk well. If they become afraid to lend simply because of the consequences of making a loan that goes bad, our economy will suffer.”

So it does seem true that Lowe fears the banks will overreact to the punishment and tighter regulation imposed on them following the royal commission’s findings, and that this could lead to them crimping economic growth.

(Just how concerned Lowe is about this is something the media can only speculate about. Top econocrats will always be sotto voce, for fear a loud shout of warning may be self-fulfilling. The media trumpet dire predictions because they don’t imagine anyone will take them seriously.)

Back on the public’s trust, having clear lines of accountability can help. But “we should not lose sight of the fact that it is the banks’ boards and management that are ultimately responsible for the choices that banks make. Creating the right culture is a core responsibility of boards and management.”

One thing that would help, Lowe says, “is for financial institutions to a have a long-term focus and reflect that in their internal incentives. Managing to short-term targets might boost the share price for a while, but this short-termism can weaken the long-term franchise value of the bank.

“I would argue that the franchise value is more likely to be maximised if our financial institutions have a long-term perspective, treat their customers well, reward loyalty rather than take advantage of it, and invest in systems and technology that deliver world-class financial services . . .

“Doing this would not only be good for bank shareholders, but also for the broader community.” Well said.

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Worried officials opt for risky strategy

My guess is the Reserve Bank is a lot more worried about the weak state of the economy than it's prepared to admit in its soothing words and the small downgrade to its growth forecast.

That's the only explanation I can think of for its decision to cut the official cash rate by 0.25 percentage points last week, despite governor Glenn Stevens' most recent "forward guidance" that "the most prudent course is likely to be a period of stability in interest rates".

The Reserve  could have preserved the credibility of its formal signalling regime by delaying such a tiny rate cut by just four weeks and using last week's statement to change its guidance, but such was its impatience that it reverted to its formerly forsworn practice of briefing selected journalists.

The financial markets got the message - thus giving the Reserve the self-generated justification that it had to act because the market was expecting it to - but most business economists didn't. In their naivety, most economists regard the word of the governor as more reliable than media speculation.

Despite the rate cut - and the assumption of at least one further cut - on Friday the Reserve shaved its forecast for real growth this year by 0.25 percentage points to 2.75 per cent, but left its forecast for next year unchanged at a midpoint of 3.5 per cent.

So what was so worrying that the Reserve, having sat on its hands for 18 months, couldn't wait another four weeks so as to protect its reputation?

The old story. This year has long been expected to be when mining investment spending falls hardest, leaving a huge hole in activity, to be filled by the resurgence of the non-mining economy, particularly ordinary business investment.

The Reserve worries that business investment isn't recovering fast enough. So, despite having already cut the official interest rate from its peak of 4.75 per cent in late 2011, it decided to take off another click or two.

It might make all the difference, but I doubt the high cost of borrowing is what's holding businesses back from expanding. More likely, they don't see any great scope for making a bigger buck, and they're not in any mood to try their luck.

As central banks in other developed economies have discovered, when "animal spirits" aren't helping, you can get to a point where even exceptionally low rates do little to encourage borrowing and spending, when cutting rates to encourage growth is like "pushing on a string".

There's one exception, however: borrowing for homes. The main reason the Reserve has waited so long to cut rates further is its fear this would do more to encourage musical chairs in the housing market - the buying and selling of existing homes - including yet more negative gearing.

This doesn't do much to increase economic activity, but does bid up house prices and so add to the risk of a price bubble developing, particularly in Sydney and Melbourne.

It also leads to faster growth in household debt. Saul Eslake, of Bank of America Merrill Lynch, notes that after stabilising for some years, the ratio of household debt to annual household income has been rising to more than 150 per cent and will now go higher.

With their official interest rates down virtually to zero, the Americans, Europeans and Japanese have already got close to the limits of monetary policy. They've had to resort to "quantitative easing" (creating money out of thin air), but this has done a lot more to distort exchange rates and inflate prices in asset markets than it has to encourage real economic activity.

At 2.25 per cent, our official rate is still well above zero but, even so, we're close to the point where the costs and risks of a rate cut threaten to exceed the benefits.

The upshot of the great battle between Keynesians and monetarists in the 1970s was agreement that monetary policy was the most effective way to fight the opposing evils of inflation and unemployment.

By the 1990s, some concluded that manipulation of interest rates by independent central banks had conquered the problem of keeping economies on an even keel. Yeah, sure.

We discovered a fatal weakness in the new macro management: monetary policy was great at controlling ordinary inflation, but when used to stimulate weak demand it was prone to encouraging excessive borrowing and asset-price bubbles which, when inevitably they burst, caused deep and protracted "balance-sheet" recessions.

From our perspective, the answer to our present problem isn't more risky rate cuts, it's greatly increased federal spending on infrastructure to fill the hole created by the fall in mining investment.

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ECONOMICS FAQ

Talk to VCTA Teachers Day, Melbourne, Friday, August 23, 2013

Often when I talk to economics teachers I focus on helping them keep up to date with the latest thinking on some topic, believing they need to know a lot more background information than their students do and leaving it for them to decide how much of what I’ve said they need to pass on to their kids. But this time I’m going straight to the classroom to give you answers to what I imagine are frequently asked questions by your students - and maybe even by you. The full version of my speech is a lot longer than I’ll have time to talk to today, so make sure you get a copy. Even so, I’m sure there are many more FAQs than I’ve had time to write about - or even think of. So if you’ve got questions I didn’t answer, I’d be grateful if you’d write them down and give them to me - or send me, if you think of them later - and I’ll use them for another talk or bear them in mind for my Saturday column, which has high school economics students as primary target audience.

Can we trust the official unemployment figures?

Short answer: yes and no. Yes we can trust the figures in the sense that, contrary to a widely believed urban myth, there was no time in the past when some government - Labor or Liberal - doctored the figures to make them look better. The figures are calculated by the Bureau of Statistics, which is not a government department but, like the ABC, has a high degree of independence of the elected government and doesn’t let politicians tell it how to measure things. The bureau, which is regarded as one of the best statistical agencies in the world, sticks closely to the statistical conventions laid down by the UN Statistical Commission, the IMF and, in the case of the labour force survey, the ILO. The definitions it uses to decide who is employed, unemployed or ‘not in the labour force’ haven’t changed significantly for many decades.

Remember that the labour force figures come from a sample survey conducted every month by the bureau, using a sample of 26,000 households - up to 20 times those used in media opinion polls. Even so, this does mean it is subject to sampling error, and the results jump around from month to month, meaning it’s best to look at the ‘trend’ (smoothed seasonally adjusted) figures.

Many people assume that the number of people said to be unemployed by the bureau is the same as the number on the dole. This isn’t true. You can be on the dole but not counted as unemployed in the survey (say, because you picked up a few hours of casual work during the week) or you can be counted as unemployed by the survey but not on the dole (say, because your spouse’s job gives you too much income to be eligible). Some old people have ideas in their heads that are a hangover from the time before 1978, when the Fraser government paid to have the labour force survey moved from quarterly to monthly, so that it replaced the old method of measuring unemployment as the number of people registered with the Commonwealth Employment Service.

I suspect some people’s false memories of the government fiddling with the figures stem from their memory of controversies over governments changing rules about how much work you can do and still be eligible for disability benefits or the dole. It’s sometimes claimed that a government has tried to hide some of the unemployed by putting them on training schemes. But people have been making such claims for years and the claim implies the training schemes are phoney, that they’d be of little value to the job seeker and are motivated only by a desire to fudge the figures. Whether a person is classed as unemployed depends not on how they’re classified by a government department, but on what answers they give to the bureau’s interviewers.

So, yes, we can trust the official figures in the sense that they haven’t been fiddled. But, no, we can’t trust them in the sense that they don’t give an accurate picture of the extent of unemployment. It is true - and has been for decades - that, under the international convention, someone who’s done as little as an hour’s work in the previous week is classed as employed, not unemployed. This means the official definition of unemployment is too narrow, making it too hard to qualify as unemployed and thus understating the full extent of joblessness. Note that very few people actually work only a few hours a week. It’s also true that the majority of people working part time (ie less than 35 hours a week) are happy with the number of hours they’re working. Many full-time students, young mothers and semi-retired people don’t want to work full-time.

Even so, a significant number of part-timers do wish they could get more hours, so we have a significant problem with under-employment. I suspect this measurement problem has arisen because the decision to call someone employed if they worked for only a few hours was made long ago when part-time and casual employment was quite rare. As it has become increasingly more common, the original definition of unemployment has become increasingly misleading.

The bureau has tacitly acknowledged this by calculating the rate of underemployment and adding this to the official unemployment rate to get the rate of ‘labour force underutilisation’. This broader measure of unemployment is calculated every quarter and published with the monthly labour force survey. From July 2014 the bureau plans to calculate and publish the broader measure monthly. Let’s hope this will prompt economists and the media to give it more attention.

In May 2013 the trend unemployment rate was 5.5 pc, while the underemployment rate was 7.3 pc, giving an underutilisation rate of 12.8 pc. Note that the measure counts as underemployed not just people working part-time who’d prefer to be full-time, but also those part-timers who’d like only a few more hours. So to that extent its definition of unemployment is probably a little too broad.

For many years I’ve used the rough rule of thumb that the easy way to correct the official unemployment rate is to double it. If you’re making comparisons with the past, however, you have to remember to double both the starting point and the end point. And remember that even if the level of the official rate is too low, it should still give a reasonably reliable indication of whether unemployment is rising, falling or staying the same.

Does the RBA still control interest rates when the banks can do as they please?

Short answer: yes it does. The RBA uses market operations to keep the overnight cash rate under very tight control. The cash rate has acted - and still acts - as the anchor for all other short-term and variable interest rates. Of course, all the other interest rates - from bank bill rates to mortgage interest rates - are a margin (or ‘spread’) above the cash rate because they involve riskier lending, but for several years before the global financial crisis world financial markets were very steady and those margins changed little. This gave people the impression mortgage interest rates always move in lock-step with the cash rate. After the turmoil of the crisis, however, many of the margins widened. The banks passed this increase in their cost of funds on to their borrowing customers. In the case of people with home loans, the banks did this by increasing their mortgage interest rates by more than any increase in the cash rate, or by failing to pass on the whole of any cuts in the case rate. Note that the banks increased the rates they charge their business borrowers by a lot more than they increased the politically sensitive mortgage rates.

For a brief period during the GFC the overseas financial markets in which our banks borrowed a high proportion of the money they lent to their customers ceased to operate. When trading resumed their margins were a lot higher. Realising the extent of our banks’ over-dependence on overseas ‘wholesale’ markets, the share market, the credit rating agencies and the official regulators put pressure on our banks to borrow more of the funds they needed from domestic depositors, whose deposits tended to be ‘sticky’ (slow to move away in search of higher returns) and thus more dependable. The resulting sudden surge in all the banks’ demand for deposits forced up the interest rates they paid on deposits, particularly term deposits, raising them from below the cash rate to above it. This, of course, was a great benefit to Australian savers, but the banks passed this higher cost on to their borrowers.

Could the banks have absorbed these higher borrowing costs? They could have - their profitability (not just the absolute size of their profits, but the rate of their profits relative to the value of their total assets or their shareholders’ capital) is very high by world standards or by the standards of other Australian industries - but they chose not to. And the limited degree of competition between the members of the big-four banking oligopoly gave them the pricing power to pass their higher costs on to borrowers and preserve their rate of profitability.

But don’t confuse the rights and wrongs of the banks’ actions with the quite separate question of whether their behaviour has robbed monetary policy of its effectiveness. It hasn’t. Why not? Because although the RBA uses the cash rate as its instrument, what does the real work of monetary policy are the market interest rates actually paid by businesses and households, so the RBA focuses on getting market rates where it wants them to be. If the independent actions of the banks cause market rates to be higher than where the RBA wants them, it simply cuts the cash rate by more to achieve its desired result. In other words, the fact that the banks’ margin above the cash rate is now wider than it was before the GFC simply means the RBA has had to cut the cash rate by more than it otherwise would have to get markets rates to where it wants them.

Does monetary policy still work?

Short answer: yes. When the share and property markets were booming in the late 1980s, the RBA spent several years raising interest rates to get the boom under control. The rise in rates didn’t seem to be working, and it became fashionable to say that monetary policy had become ineffective. I was still wondering whether this could be true when the economy started the slide that became the recession of the early 90s, the worst recession since the Depression, in which unemployment got close to 11 pc. Then all the smarties started saying interest rates had been held ‘too high for too long’.

There could be no better experience to cure me of ever doubting that monetary policy was effective. And yet we hear such claims whenever people observe a delay between the RBA starting to move the cash rate and making clear its desire to speed up or slow down demand but nothing seems to be happening. When the RBA cuts the rate but there’s a delay before demand picks up, people use an old Keynesian phrase that using interest rates to try to stimulate demand is like ‘pushing on a string’. But that analogy is appropriate only when the economy is in a liquidity trap - which the North Atlantic economies may be in at present, but we certainly aren’t.

In 40 years of watching the management of the Australian economy I can’t recall any time when monetary policy has failed to move demand in the desired direction. The problem is just that, as you well know, monetary policy operates with a lag that’s ‘long and variable’. Another thing that makes the process slow and adds to people’s impatience is that the RBA almost invariably moves in baby steps of 0.25 percentage points. Clearly, a single 25 basis point change isn’t likely to have a big effect on decisions about borrowing and spending. It’s probably true, too, that the response to a monetary tightening or loosening episode isn’t proportional or linear. That is, you may adjust rates several times without getting much effect, but then anther click finally has a big impact. The RBA uses the rule of thumb that most of the effect of a monetary policy on demand occurs within two years, with maybe two-thirds of the full effect occurring in the first year. The effect on inflation - which, of course, runs via the effect on demand - is longer again.

Would a big cut in the cash rate produce a fall in the dollar?

Short answer: no. This question has been asked a lot in recent times as trade-exposed industries such as manufacturing have be hard hit by the high dollar associated with the resources boom.

The first point to understand is that, in practice, economists don’t have a good handle on what factors determine movements in the exchange rate over short periods of less than a year of so. There are rival theories, but no particular theory always gives a convincing explanation of why the exchange rate has moved - or not moved - as it has in recent weeks. Instead, one theory tends explain recent events better than another does at a particular time, so economic practitioners tend to switch between the rival theories depending on which one seems to be working better at the time. I think the reason no theory seems to work well at all times is that the global foreign exchange market isn’t nearly as rational as the perfect market hypothesis assumes.

In the old days, a common theory was that the currency of a country with an excessive current account deficit would tend to depreciate, so as to help bring it back to equilibrium and, similarly, the currency of a country with an excessive current account surplus would tend to appreciate. These days, you rarely hear this theory relied on because there’s little if any empirical support for it. I think it was a hangover from the days of fixed exchange rates, when it was clear the authorities’ decisions on whether to devalue or revalue the currency were determined by pressures on their current accounts. In these days of floating currencies and the removal for foreign exchange controls, it’s clear the ‘driver’ of floating exchange rates has switched from the current account to the capital account - that is, from trade flows to capital flows.

These days, and particularly from an Australian perspective, there are three main, rival theories to explain exchange rate movements. The first is that the biggest influence over our exchange rate is our terms of trade, and particularly world primary commodity prices. There is much empirical support for this view if you look at a graph of the two over the years, though you can see the correlation breaking down over some shorter periods. The second theory is that the biggest influence over our exchange rate is our ‘interest-rate differential’ - the size of the difference between our official interest rate (or short-term commercial rates) and those of the major developed economies, particularly the United States. The higher our rates are relative to the others, the more our exchange rate is likely to be high and rising, and vice versa. Note that this is very much a capital-flows driven theory. The third theory is a kind of combination of the first two: countries with strong economic prospects relative to the major developed countries should have strong currency, whereas countries with weak prospects relative to the majors should have a weak currency. This theory makes a lot of sense and often seems to be pretty true, but there are times when it’s far from true.

Australia’s very strong exchange rate over most of the past decade is commonly explained by the resources boom and our exceptionally favourable terms of trade as a result of record high prices for coal and iron ore. Its rise can not be explained by any increase in our interest rates relative to the major economies, even though their rates have been at rock bottom since the global financial crisis. But this has not discouraged people adversely affected by the high dollar from convincing themselves the high rate is the product of currency market speculation or our relatively high rates since the GFC, and then arguing the RBA should make a big cut in our cash rate with the express purpose of engineering a big fall in the dollar.

Our terms of trade began falling in about September 2011, but the dollar didn’t start to fall until April 2013. This delay probably encouraged people to switch to a different theory. They may have thought the RBA was being too cautious in the speed at which it was bringing rates down.

Although no one can be too dogmatic about these things, the RBA does not believe the interest rate differential has very much effect our exchange rate. And this is despite the signs we see that expectations about whether the RBA will or won’t move rates haves an immediate effect on the bill rate. These effects are very temporary. During the period in which the RBA was lowering rates and openly expressing its hope that the dollar would fall to a more appropriate level, many people concluded it was cutting rates in the hope this would lower the exchange rate. It wasn’t. Rather, it was loosening monetary policy because the exchange rate wasn’t coming down. That is, it was trying to ease pressure on the tradeables sector as a substitute for a lower dollar.

Although the Aussie stayed high for about 18 months after commodity prices had fallen sharply, it has fallen by about 10 per cent since April 2013. Some people may attribute this to steady easing in policy over most of that time, but the BRA doesn’t agree with them. A much more likely explanation is that the Aussie finally began falling when Wall Street began worrying that the long-awaited pickup in the US economy would prompt the Fed to start ‘tapering’ the size of its quantitative easing. QE - the central bank’s purchase of bonds and other securities which are paid for merely with bank credits - puts downward pressure on a country’s exchange rate.

The point to note is that the exchange rate is a relative price - the value of my currency relative to the value of yours. So it shouldn’t be so surprising that changes in the level of our exchange rate need to be explained in terms of changed conditions in the US as well as changes in Australia.

Why are our interest rates always higher than other people’s?

Short answer: because we’re riskier. It’s true our interest rates are almost invariably higher than those in the major economies. This has been true for many years. It wasn’t hard to understand before the mid-1990s - when our inflation rate was still well above everyone else’s - but it remains true even when you compare real interest rates.

The explanation seems to be that, as a nation of perpetual net borrowers from the rest of the world (we run a persistent current account deficit), we are required to pay our foreign lenders a significant risk premium on top of the going international rate to compensate them for the extra risks they run in lending to a country that already has a very large net foreign debt and that, being a relatively small economy, is perceived to be more volatile (even though that’s not always true).

Another way of putting it is that Australia always has higher interest rates because we’re a country with an abundance of potentially profitable investment projects relative to the major economies. Our projects have to be relatively profitable or we wouldn’t be able to continue borrowing despite the high risk premium foreign lenders require us to pay.

Does a budget deficit mean fiscal policy is expansionary and a surplus mean it’s contractionary?

Short answer: no they don’t. Life would be very simple for students of macroeconomics if they did, but unfortunately they don’t. Why not? Because what macro economists focus on is not the level of economic activity, but the change in the level - that is, whether the economy has been/will be expanding or contracting. That means they’re interested in determining whether the budget - fiscal policy - is making a positive or negative contribution to economic growth. So it’s the change in the budget balance - and the direction of the change - that matters when assessing whether a particular budget is expansionary or contractionary.

These days the RBA and most market economists assess the stance of policy adopted in a particular budget simply by looking and the direction - and size - of the expected change in the budget balance between the previous year and the budget year. An expected reduction in a deficit or increase in a surplus is regarded as contractionary; any expected increase in a deficit or decrease in a surplus is regarded is expansionary. As a guide, the change needs to be equivalent to at least 0.5 pc of GDP to be significant. A change of 1 pc or more is extremely significant.

Strict Keynesians, however, define the stance of fiscal policy differently, distinguishing between changes in the cyclical component of the budget balance (caused by operation of the budget’s automatic stabilisers as the economy moves through the business cycle) and changes in the structural component (caused by governments’ explicit changes to taxes and spending programs). So they define the stance of policy adopted in a budget according to the direction of the expected change in the structural component arising from the net effect of the spending and taxing changes announced in the budget. They ignore the change in the budget balance caused by the economy’s effect on the budget, focusing on the change caused by the budget’s effect on the economy.

Note, changes in the stance of fiscal policy will be only one of the factors contributing to whether the economy is expanding or contracting. Other factors include: the stance of monetary policy, movements in the exchange rate, changes in the world economy and in confidence.

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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.

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