How the RBA can have it all

The Reserve Bank has lagged the market for 18 months in cutting rates. In February 2011, the bank expected inflation by the end of 2012 to be at the top of the target band, with output growth above trend. Instead, inflation is near the bottom of the target band and output growth is dropping below trend. This is despite the cash rate falling from 4.75 per cent to 3 per cent.

This major misreading of the economy has been uncomfortable, rather than disastrous, because unemployment has remained subdued despite hours worked hardly changing over the last year. People have stopped looking for work and employers have reduced hours worked rather than sacked people. The mining booming disguised how slowly the rest of the economy was growing and how far rates needed to fall to generate reasonable non-mining growth.

Probably half of output growth recently has been in mining and related sectors. The 80 per cent of the economy in non-mining sectors has grown only 1-2 per cent, or close to recession levels. Not surprisingly, wages and inflation pressures are subdued as a result.

I fear there is more pain coming. Falling export prices mean that real national disposable income per head is declining, even though real output is rising. Essentially, we can buy less with what we produce. Weak real income growth is likely to mean slower demand growth next year.

Unless new projects are committed to soon, mining investment will start subtracting from output growth, as will federal and state budget cutbacks. While mining output will rise as projects currently under construction are completed, mining output growth is not going to be faster than this year's 10 per cent. The mining and related sectors may provide only 1 per cent or so of total output growth in 2013.

Despite the Reserve Bank's hopes, it seems unlikely that other sectors will make up the gap next year to allow the economy to grow near its trend of 3 per cent. Non-mining investment will be weak for some time given the high Australian dollar and slow demand growth. Private consumption therefore has to accelerate, or overall output growth will be well below trend. Yet a household spending surge seems unlikely given global problems hitting confidence, little growth in hours worked and caution about running up debt.

Further interest rate cuts will be needed to avoid unemployment rising, even without offshore disasters.

The Reserve Bank will be reluctant to cut rates sharply. Reserve Bank governor, Glenn Stevens, in a recent speech in Thailand on the challenges for central banking, expressed concern about low interest rates stimulating risk-taking behaviour and leading to rising asset prices, higher leverage and declining lending standards. The Reserve Bank is worried that pushing rates too low for too long could cause house prices to boom and result in financial instability down the track.

Stevens flagged that macro-prudential tools are being used increasingly overseas and may have a role to play. The interest rates appropriate for the overall economy may stimulate excessive borrowing in sectors like housing. He argued that it may then be sensible to implement sector-specific measures such as loan-to-valuation rules, or capital requirements to dampen demand in those sectors. However, he warned that if rates are too low for too long, regulation will not work. If the incentive to borrow is powerful and persistent, people will find a way around regulation. This suggests the Reserve Bank will be wary about keeping rates low for long.

Yet low rates elsewhere are attracting funds into the Australian dollar and holding our exchange rate at distorting levels. To cut rates aggressively here in response would risk creating domestic distortions in asset markets. Setting policy is never easy.

Rates here should still be cut sharply as long as inflation and output growth remain subdued. If that causes surging house prices we should respond by tightening housing loan-to-valuation ratios and capital requirements.

Rather than hold interest rates too high, we need to use regulation to limit problems lower rates may cause in specific sectors. Many countries overseas now use announced changes in regulatory rules, while Australia still prefers tight individual bank supervision behind the scenes. As time passes we will get more evidence from overseas about what regulatory controls work best. Just as we adopted inflation targets to make monetary policy transparent, announcing shifts in required housing deposits or bank reserve requirements could support tight individual bank regulation. It would allow the Reserve Bank to signal its concerns clearly to both lenders and borrowers.

I think the Reserve Bank has made mistakes in monetary policy settings recently. However, we are much better with independent experts setting policy than to be at the mercy of the short-term political cycle.

Dr Ed Shann is an independent economist.