How to limit looming interest rate rises

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Setting rates by the rules has worked a treat

I touch wood as I say this - hubris has a long history in economics - but we're doing a lot better at the day-to-day management of our economy than we used to.

That's clear when you compare our management with most of the rest of the developed world at present, but it's also clear when you look back on our performance over the years.

When I got into this business 36 years ago, the economy was out of control. So was the budget deficit. And monetary policy wasn't much better.

But progressively from the election of the Hawke government in 1983 we've got things under control. How? Micro-economic reform has helped by making the economy more flexible, more resilient in the face of shocks to the economy, and less inflation-prone.

The floating exchange rate has been a great boon, shifting up or down in just the direction needed to help us cope with a particular shock, in precisely the way predicted by the textbook.

But also because of macro-economic reform: improvement in the way we deploy the instruments of macro management - monetary policy and fiscal policy. We've adopted ''frameworks'' or rules to guide the conduct of policy, we've stuck to them, and they've worked.

With monetary policy, for instance, we adopted the latest fashion of making the central bank independent of the elected government and giving it an inflation target. We designed our own flexible target - to hold inflation between 2 and 3 per cent, on average, over the cycle - which foreigners criticised as too high and too imprecise, but eventually came to accept (and imitate) as more sensible than their lower, less flexible targets.

Guess what the inflation rate has averaged over the 17 years we've been pursuing that target? Excluding the one-off effect of the introduction of the goods and services tax in 2000, 2.5 per cent - bang in the middle of the target.

And while we've been keeping inflation under control we've made steady progress in lowering unemployment.

We've been particularly well served by the three econocrats who've had charge of the Reserve Bank and monetary policy over that time. Bernie Fraser pioneered the new way of operating - he showed his successors how it was done - and had a great feel for how the economy was travelling.

Ian Macfarlane was highly perceptive in discerning changes in the forces affecting the economy, being the first to identify the role the financial economy played in the severe recession of the early 1990s and the implications of a protracted period of ''balance-sheet repair'' (now known as ''deleveraging''). He was never taken in by the fashionable enthusiasm for the (elegant but stupid) ''efficient markets hypothesis''.

Glenn Stevens has been notable for the courage with which he has, when necessary, raised interest rates without political fear or favour, and for the alacrity with which he's changed direction when the economic winds have switched suddenly, as they did in September 2008.

He's built on the lead of his predecessors in greatly increasing the role of ''liaison'' - systematic consultation with big firms and industry groups in each of the states - in seeking to bridge the gap between casual anecdotal evidence and belated, oft-revised official statistics.

I particularly admire his realism and frankness about economists' poor forecasting record. As he said in a speech this week: ''The future is of course unknowable, and economic forecasts unfortunately are not very reliable. But we have no option but to try to form a view of how things will probably unfold.''

After outlining the Reserve's present ''central forecast'' he added: ''Of course that central forecast could turn out to be wrong. Something could turn up - internationally or at home - that produces some other outcome. We spend a fair bit of time thinking about what such things could be.''

The Reserve's handling of monetary policy over the 17 years hasn't been perfect, of course. In 2007, for instance, it waited too long to raise rates, having been wrong-footed by a couple of misleading results for the consumer price index.

But while at any moment there's never a shortage of people willing to criticise the Reserve's actions - particularly people living in Canberra, for some reason - when you look back on the record you don't find a lot to complain about.

When the Reserve first enunciated its inflation target many people thought it meant the central bankers cared only about inflation. Some suspected it was imposing a 3 per cent speed limit on the growth of gross domestic product.

No one says that today. Under the inflation-targeting regime, the level of unemployment has been a lot better in the past decade than it was in the previous two. And though the same can't be said of all the world's central bankers, it was never true that our Reserve had a one-eyed view of economic management.

Even so, I don't remember any of his predecessors spelling it out more clearly than Stevens did this week. Answering the question of what the objectives of monetary policy were, he said: ''Put simply, our job is to preserve the value of money over time and to try, so far as possible, to keep the economy near its full-employment potential.''

He added that ''over the long run, these are mutually reinforcing goals, not conflicting ones''. Just so. When the Fraser government first adopted the slogan Fight Inflation First, many people had doubts, including me.

But the Reserve's successful implementation of inflation targeting has proved the slogan right (in a way Malcolm Fraser and his treasurer, John Howard, never could). Keep inflation always under control and, in time, unemployment will come right.

Note, however, that once the economy is close to full employment (of all factors of production, not just labour), as it is now, then our medium-term trend rate of growth of about 3.25 per cent a year - also known as our ''potential'' growth rate - does set a non-inflationary speed limit for the economy.

Note, too, that nowhere did Stevens (or any of his predecessors) say keeping interest rates low is an objective of policy. Interest rates are seen as a means to the end of low inflation and unemployment, not an end in themselves.

But if inflation is kept under control then nominal interest rates will at least be a lot lower than in the days when our inability to control price rises saw mortgage interest rates up at 17 per cent.

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