Interest rates unchanged


In macroeconomic terms, the RBA decision to keep interest rates unchanged looks like a good call. With the levels of indebtedness we have in Australia, the risk of overkill, as seen in 1990, are greater than the risk of delaying for a while to see what happens. Although the evidence is patchy, the claims that economic activity has peaked look quite plausible. On most reasonable estimates, interest rates are still below their ‘neutral’ level and it looks as if they can’t go significantly above this level without producing substantial damage

In microeconomic terms, the decision looks far less appealing. Interest rates represent the price of current consumption in terms of future consumption. If they are permanently held below their equilibrium (roughly the same as neutral) level, the result must be too much consumption and too little saving and Australia has seen this in spades, with negative rates of household savings for some years. Not surprisingly, this has been accompanied by a boom in asset prices, particularly for residential land. This in turn has been associated with a shift in investment towards housing which, since it produces non-tradable services, is not helpful in addressing a huge current account deficit.

When one set of considerations strongly suggests holding interest rates steady and another suggests they need to rise significantly, the obvious conclusion is that we are trying to do too much with one instrument.

24 thoughts on “Interest rates unchanged

  1. Thank goodness common sense prevailed.

    Are we in a period of sustained lower interest rates due to the large volume of money trying to find someone able to service the cost of it? (Caused by baby boomer superannuation savings). Our 2 major trading partners the US and Japan have had historically low interest rates for a long period.

    If we are in a period of sustained lower interest rates, could this be the last tightening in this cycle? (this is the 5th)

    With regard to the savings level would it be true to say the government has effectively transferred its debt to the private sector?

  2. One of the instruments most obviously lacking is an industry policy. The Coalition government has always been supinely content to view Australia as a “hole in the ground” for foreign-owned miners to exploit at will. Recent Govt. crowing about Australia’s rising investment levels (see your post “Back to the 1950s” of 7/3/05 and especially the comments thread) may imply to some that Australian industry is doing fine without any Federal Govt. policy assistance. I’m not so sure. As I said in that thread, it would be nice to see some analysis of disaggregated investment numbers so we could see where the money is going and where it is coming from. This might provide a jumping-off point for a reopening of the industry policy issue, an issue which our abysmal balance of trade should keep on Page One.

  3. John

    I thought interest rates were a macro policy instrument, used for controlling inflation, and not a micro policy instrument. So the only question the RBA has to ask itself is what interest rate setting is needed to keep inflation within its target band of 2-3 per cent.

    The issue of whether savings is too high or too low is a separate question (unless strong consumption poses an inflationary threat). If there is concern over this then I would suggest other instruments be considered.

    However, personally I am not so concerned about this. First, the levels of business investment remains quite high, implying our productive potential is still growing. Second, I see no compelling reason to interfere in the intertemporal decisions that individuals are currently making.

  4. The RBA decision does not make sense.
    According to the Melbourne Institute/ TD Securities index , which has a good relationship with the CPI, inflation is running at an annualised rate of 4% which means they are behind the curve.
    Not surprising given that interest rates are still accommodative level.

    We are heading into interesting times.

  5. Steve Edwards, this isn’t really news. For several years now, NATSEM has been saying that transfer payments of various kinds have been preventing the emergence of really gross inequality.

    But if viewed through the “half-empty glass”, darkly, NATSEM have really been saying that the only things retarding the emergence of really gross inequality and poverty are transfer payments of various kinds, and what an unstable and unreliable factor they are!

  6. “On most reasonable estimates, interest rates are still below their ‘neutral’ level…”

    I know you’re pretty orthodox when it comes to macro,John. Nonetheless, I’m a bit surprised to find you cheerfully adopting this concept. It’s easy enough to write down a model that determines an equilibrium interest rate in some fashion, but I’ve never seen seen anyone ‘estimate’ one convincingly. Have you? I know it’s firmly established now in the jargon of the practical central banker, but does anyone claim they can identify a neutral/natural/equilibrium interest rate? Other than in hindsight, that is. If we’re going to be estimating things, I’d estimate that the neutral rate of interest is about half as respectable as the natural rate of unemployment (which it predates by seventy years), which is not saying much.

  7. Homer

    The annualised rate you are talking about is based on the March quarter alone. Inflation fluctuates from quarter to quarter and looking over a full year the MI/TD index is still only rising by around 2.5 per cent.

    In any case, if inflation was running at 4 per cent now it would be a sign that the RBA got monetary policy wrong about 12 months ago, given the lags between policy changes and impact on inflation. What is important for the current interest rate settings is what the inflation outlook over the next 12 months is. With the economy slowing it is hard to see where the inflationary pressures are going to come from.

  8. Transfer payments are certainly unstable and unreliable…if you have to pay taxes to support the transfer payments.

    In 1998, the welfare bill was $50 billion. That figure was $80 billion in 2004 – a 60% nominal increase. Welfare made up 37% of the federal budget in 1998. That figure was 44% in 2004.

    With an enormous effective marginal tax rate of 87% for welfare recipients who earn more than $230 a fortnight, there are absolutely no incentives to find work.

    There is, however, an incentive for job seekers to get two and a half hours work a week and send 5th rate resumes to – Centrelink is happy because they are “looking for work”, and the Job Network is happy because their client has “casual employment”.

    That’s not to say we should bash “dole bludgers” for doing what any sensible person would do under the circumstances – it’s just that we have created an incredibly bloated transfer system which punishes people who want to work hard.

    We are probably sacrificing a few percentage points of GDP due to this ridiculous situation, and that is bad for “poverty”.

  9. James, I agree it’s a rather slippery concept, but if we can’t talk about “neutral” in this sense, we also can’t talk about “expansionary” or “contractionary” monetary policy, which seems to make discussion impossible.

    The “natural rate” is different in the sense that implies a very specific and empirically dubious analysis based on a vertical Phillips curve.

  10. Mark, I do realise that however it does give us a good idea if inflationary forces are on the march and I suspect they are.

    James the ‘Taylor’ rule is about as good as you can get on this and this concept suggest a few more increases before monetary policy becomes neutral.

  11. Yes, Steve Edwards, the welfare “bill” (the meaning of this is arguable, but leave that aside) is big enough to create a groundswell of concern and opposition, just as the PBS bill has done. But without these things, as NATSEM has repeatedly shown, the bottom falls out of the earnings of the lowest income deciles. Wouldn’t it be much more sensible and in the long term more stable to find them jobs which pay enough to live on with dignity? Hence my concern with industry policy.

  12. we are trying to do too much with one instrument

    Indeed. It goes back to the lack of any real macroeconomic policy from the government you’ve written about several times, John.

  13. In response to doing too much with the one instrument, I am genuinely interested in what other options there could be.

    Any suggestions? Or perhaps that could be future post for Prof Q.

  14. Homer: Where is the evidence that inflation is on the march? It can’t be seen in wage growth figures. And the slowing down in the economy is likely to remove any inflationary pressures.

    Mark B: The lack of any real macroeconomic policy has coincided with unemployment at a record low, very strong business investment and inflation in the 2-3 per cent target range.

  15. Yes, Mark U, but with some very worrying warning signs at the moment. Certainly fiscal policy has been all over the place – as the 66 billion election spending spree shows. I’ll simply refer back again to the posts John put up last year on this topic.

  16. Yes, Mark (Upcher), but then there’s the little matter of the current account, which John alludes to. Confriming the adage that great and mediocre minds think alike, I made the same point about targets and instruments here.

    John, if you just mean monetary policy that’s not intended to be expansionary or contractionary that’s fine. As long as no-one imagines there is some underlying Wicksellian or Walrasian equilibrium rate that neatly reconciles productivity and thrift.

    And Homer, any Taylor Rule will have a neutral rate implicit in it, but that’s not saying much. Just because decsions are not arbitrary doesn’t mean they’re not based on wild guesses.

  17. Mark, I citied it. The Melbourne Institute/ TD Securities inflation index.

    James , I wasn’t saying that the RBA wa making wild guesses merely loking at interest rates along the Taylor Rule they are still expansionary.

  18. Homer: From the MI-TD press release:

    “Dr. Don Harding, an economist at the University of Melbourne and co-creator of the Inflation Gauge, said that,
    “Given that prices rose by 1.4 per cent over the first three months of 2005 it is highly likely that year ended
    inflation will move towards 3 per cent over the course of 2005. In such circumstances it is natural that the RBA
    and markets will be alert to the possibility that sustained price pressure could push inflation above 3 per cent.�
    “However, the price rises in March were less broadly based than in January. In March prices rose in 27
    expenditure classes, fell in 16 and remained the same in 46 expenditure classes giving a net balance of 11. The
    comparable data for January involved 34 rises, 19 falls and 36 unchanged for a net balance of 15. There is little
    in this data to suggest a persistent broadly based increase in price pressure. Of course, such price pressure might
    emerge in future months but that outcome is by no means certain,â€? Dr. Harding added.”

  19. Mark, I merely made the point that if you annualised the figure they are behind the curve.

    It is annualised figures against annual figures.
    It is the best we do here in the no monthly inflation figures in Australia.

  20. Homer: You still seem to be missing the point (made by Don Harding) that based on the MI/TD index the underlying inflationary pressures at present do not seem to be all that great. Just because we go above the target band on an annualised basis is not a good reason for the RBA to push rates up, nor is it a reason to say that the RBA is getting monetary policy wrong.

  21. James: Assuming you think the current account is a problem, what macro policy should we use to target it? Did the Labor government have any successful policy during its period in office?

  22. Hi… Stupid question but… just wondering.. so if the RBA increase the interest rate, what would be the implication to household debt… I’m guessing that many people wouldn’t be able to pay off their debt right?? Yeah… just that really, I’m actually doing an assignment on this.. (First year finance student) and sort of confuse…well.. really confuse… can someone help me… thanks a lot (^^)

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