Economics and finance | Australia

2 August 2016

The Reserve Bank of Australia has been quick to raise the official cash rate when they perceive inflationary forces, but slower to lower the rate when those forces abated, John Hewson writes.

The Reserve Bank of Australia (RBA) prides itself on its “control” of inflation over the last several decades, particularly since the 1980s, and especially after it formally adopted inflation targets in the 90s. To say that they have been paranoid about inflation would perhaps be a bit harsh, but they have consistently exhibited a strong anti-inflation bias throughout this period.

In general, the RBA has tended to be very quick to raise the official cash rate whenever they perceived a re-emergence of inflationary forces, but conspicuously slow to lower rates, as clear signs emerged that inflationary forces were abating.

However, I suggest that they have consistently misread the inflationary situation in recent years, especially since the global financial crisis (GFC). To be specific, in response to the GFC, which clearly threatened to tip at least the developed world quickly into deep recession, they lowered our rates slowly, and by significantly less than did most other developed economies – from their pre-GFC peak of 7.25 per cent in August 2008 to about 3 per cent in April 2009.

Then, in fear of a resurgence of inflationary pressures, they started to raise the cash rate again, to 3.25 per cent in October 2009 and 4.75 per cent in October 2011, while key global rates were near zero. Since then, they have consistently, but very slowly, lowered the rate to now sit at 1.75 per cent; an historic low, but still well above most of the rest of the developed world, which still sits with rates near zero, or in some cases negative.

Given the sustained weakness of the global economy since the GFC, and especially with China slowing faster than admitted, with wages generally flat, the fear of deflation has been a significant challenge, especially in Europe and Japan, but at times more broadly.

To a simple monetarist economist who believes in a pretty direct and consistent link between monetary expansion and inflation, the flooding of the world with liquidity (quantitative easing) by key central banks post-GFC, raised the concern of a rapid return to global inflation.

But, this simple relationship, that was almost taken for granted, has broken down post-GFC. Because despite the massive injections of liquidity, we haven’t seen a sustained pick up in economic activity, especially in business investment, and certainly not in global inflationary forces.

Today, key central banks have blown out their balance sheets quite alarmingly, and now sit with very low rates and with little capacity to stimulate their economies further, if, as is happening, global growth continues to weaken. Further, most of these developed economies have little capacity to stimulate with budgetary policy either, as they remain burdened with sizeable budget deficits and high levels of total debt.

While perhaps politically more difficult than it has ever been, the only solution seems to be broad-based structural reform in most developed economies.

Our economy is much weaker than has been admitted in budget forecasts, especially as China is much weaker than recognised here, and the global economic and geo-political risks are considerable and mounting.

This is clearly confirmed by last week’s inflation number, a 17-year low, with just 0.4 per cent in the June quarter, and an annual rate of just 1 per cent, well below the bottom of the RBA’s 2-3 per cent target range.

With our wages flat, and our measured standard of living falling, it’s reasonable to ask why the RBA still holds the official cash rate as high as 1.75 per cent, especially when it holds our exchange rate higher than it needs to be.

This is especially so when you look at the measured components of this inflation outcome. Apart from the usual petrol rip off, and an increase in health insurance premiums, and tobacco, most major categories were flat or negative, making it hard to spot the inflation bogeyman!

Of course, while it probably would have made little difference to our growth, or prospects, it is very hard to see why the cash rate is not as low as 1 per cent or less, except for the RBA’s bias.


This piece was also published by the Southern Highland News.

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Hewson, John. 2016. "Too Little, Too Late? - Policy Forum". Policy Forum.