- The Reserve Bank of Australia (RBA) has kept official interest rates unchanged at 1.5% since August 2016.
- Australian inflation and wage pressures are weak, and many suspect policy settings could remain at current levels well into next year or perhaps even longer.
- But former RBA Board member Warwick McKibbin believes the bank should be increasing interest rates now to help build a buffer for when the next global economic downturn hits.
The Reserve Bank of Australia (RBA) has kept official interest rates unchanged at 1.5% since August 2016.
Most economists and traders think that period of policy inaction, already the longest on record, will persist well into next year, maybe longer, as the RBA waits for wage and inflationary pressures to build.
Given elevated levels of labour market slack, along with weak productivity growth, many believe it will be years before the RBA is confident enough that inflation is moving back towards the mid-point of its 2-3% medium-term target.
Throw in recent declines in Sydney and Melbourne home prices, as well as growing trade tensions between the United States and its major trading partners, and the risk that the next move in the cash rate may be lower, rather than higher, also appears to be growing.
To Warwick McKibbin, Australian National University economist and former RBA Board member, keeping official interest rates at record-low level for such a prolonged period of time will leave the Australian economy vulnerable when the next global downturn hits.
“The bank has backed itself into a position where it’s justifying where interest rates are based on inflation, and inflation is stubbornly low,” McKibbin said in an interview with the Australian Financial Review (AFR).
And at a time when longer-term interest rates are rising, he says there will be an “enormous amount of pain around the world”, meaning the RBA should be using this period to build buffers to help support the economy in the future.
“That shock, higher long-term rates, capital sucking out of emerging economies but also potentially Australia, gives us a big capital flight problem,” he says.
“So what position do you want to be in Australia in that world? Surely it’s not sitting on very low interest rates when the shock comes.”
Rather than keeping the cash rate steady to help bolster wage and inflationary pressures, McKibbon argues the RBA should be lifting interest rates right now, dismissing the risks of what higher borrowing costs, high household leverage and, in all likelihood, a higher Australian dollar, could do to the Australian economy.
“If the argument is ‘we can’t raise rates because if we do we could make the housing market a lot worse’, or prick some other asset bubble and cause a shock — if that’s the problem — it’s better to raise rates now than wait six months,” he told the AFR.
“If the whole reason the economy doesn’t go into deep recession is because the RBA won’t stop distorting asset prices, then we have a bigger problem than what interest rates are.”
The RBA has conducted an elongated monetary policy easing cycle since late 2011, cutting the cash rate to record low levels as inflationary pressures remained weak.
That, as McKibbon points out, has contributed to strong growth in some Australian asset prices, especially in the Sydney and Melbourne housing markets. It’s also seen household leverage increase, leading the RBA, in partnership with other Australian financial regulators, to take a more proactive stance on financial stability risks within the housing market.
While it’s only early days, this process of helping to reduce perceived risks hasn’t yet led to adverse economic outcomes.
GDP growth is picking up and wage and inflationary pressures appear to have bottomed, albeit at low levels, just as the RBA has forecast.
Should those trends continue — and that’s still seen by many to be a big “if” — it’s likely that the next move in the cash rate will be higher.
However, while there are pockets of strength in the economy, the household sector is not one of them. Household consumption was weak in the March quarter, and is currently growing just below trend levels despite record employment growth in 2017.
This partially reflects that household income growth remain soft, undermined by still elevated levels of labour market underutilisation that are acting to keep wage pressures subdued.
Many suspect that household incomes will remain subdued until further progress is made in reducing excess capacity in the labour market, something that will likely require strong above-trend economic growth over the next few years to achieve.
Despite the vulnerability that still exists over the household sector, McKibbon says it’s time for the RBA to begin shifting its focus away from inflation to nominal income growth targeting in order to build an interest rate buffer ahead of the next global economic downturn.
“It would be a mistake to argue that there is no need to change the monetary regime because the existing monetary regime in Australia has been successful,” McKibbon says.
“Monetary regimes have evolved for centuries and when they have changed it has usually been because of a crisis — the collapse of Bretton Woods or the recession that Australia didn’t need to have in 1991.”
McKibbon says that a nominal income target — moving policy settings based on changes in the value of all goods and services produced across the economy — would allow the Australian economy to better cope with climate change policies, digital disruption and the changing global economy.
And, despite the risks that higher variable interest rates could bring, particularly to the household sector, McKibbon says current nominal income growth rates suggest monetary policy settings are far easier than they should be.
“Nominal income is probably running at 6 or 7% and my rule for neutral policy would be the short-term interest rate equal to the nominal growth rate.
“We’re well below that, which means there’s an artificial stimulus in the economy which is distorting allocation of capital — that alone says you should be adjusting policy back to a more normal rate.”
In a speech delivered earlier this year, RBA governor Philip Lowe pushed back against calls that it should be lifting interest rates simply because other major central banks were doing so.
“Countries with a floating exchange rate, like Australia, still retain considerable flexibility to set interest rates based on their domestic considerations,” Lowe said in a speech delivered to the A50 Dinner in early February.
“We did not lower our interest rates to the extraordinarily low levels seen elsewhere after the financial crisis. Our circumstances were different.
“Just as we did not move in lock-step on the way down, we don’t need to do so in the other direction.”
Lowe said that it was understandable why other major central banks were currently raising rates, particularly in those where unemployment was below conventional estimates of full employment and where above-trend growth was expected.
While the RBA expects above-trend GDP growth this year and next, it doesn’t see Australia reaching full employment — deemed to be around 5% — over this time horizon.
Given that implies wage and inflationary pressures will remain soft, it suggests the RBA won’t be following McKibbon’s advice that official interest rates should be higher, especially a time when the bank deems household consumption — the largest part of the Australian economy — as “one continuing source of uncertainty”.
There’s more at the Australian Financial Review here.
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