Rate cut for a rainy day

The macroeconomic debate is reaching a crescendo, with the government releasing its economic and fiscal update on Friday and the Reserve Bank of Australia all but certain to cut interest rates to a fresh record low tomorrow.

Like interest rates, the economic debate in Australia is at a low level, with discussion of the budgetary position and the stance of monetary policy framed in political terms by both sides of politics and not analysed in economic management terms.

Low interest rates are neither good nor bad, just as high interest rates are neither good nor bad. So too whether the budget is in deficit or surplus – neither is good nor bad without any context behind it. 

Let’s look at fiscal and monetary policy from a couple of different perspectives.

If the economy is overheating, there are capacity constraints with inflation pressures building, and there are skills shortages and asset prices are approaching bubble territory, then having low interest rates, strong growth in real government spending and smaller budget surpluses or widening budget deficits would be bad or inappropriate policy.

This should be strikingly obvious.

What would be good policy in this example is high interest rates, tight government spending and smaller budget deficits/rising budget surpluses. Again, this should be obvious.

Now think of a scenario where the economy is growing below trend, inflation is low, the unemployment rate is edging higher and Australia’s trading partners are slowing.

Bad economic policy in this example would be to see high or rising interest rates, cuts in government spending and a smaller budget deficit or larger budget surplus. It is obvious.

So where is the economy now amid this feigned kerfuffle about the fiscal outlook and interest rates?

GDP growth is below trend and inflation is locked in the bottom half of the Reserve Bank’s target zone. The unemployment rate has risen by around 0.75 percentage points in the past year and is on track to reach a 10-year high above 6 per cent in the year. Wages growth is slow and decelerating and business conditions are soft.

We all know the Reserve will almost be certainly cutting interest rates tomorrow, taking the cash rate to a record low 2.5 per cent. This is clearly appropriate. No sensible person would argue that in the current circumstances monetary policy should be tight given the macroeconomic conditions.

The economic update from Treasurer Bowen and Finance Minister Wong last week showed how the budget deficit would be somewhat larger than assumed at budget time and that the path to surplus is one year longer. This is because the economy is softer, which is the very reason why the Reserve Bank is cutting interest rates. To tighten fiscal policy and pitch for an early budget surplus would be as bad as hiking interest rates, as it would compound the downside risks that are judged to be confronting the economy now.

Business has been scratching and complaining about the soft economy for some time. Policy stimulus will arrest this weakness. The business sector is obviously welcoming of the interest rate reductions as they boosts their cash flow but also should spark a lift in investment and spending.

Business should also welcome the news on fiscal policy which allows the automatic stabilisers to work – especially in the form of lower tax revenue for the government, which leaves money in the pockets of the private sector.

The current soft patch for the economy demands easier policy.

When growth lifts back to trend and above next year, both monetary and fiscal policy can, should and probably will be tightened. That will be the time to deliver higher interest rates and government spending cuts and to allow the tax receipts to flow into the government coffers.

This is how it should be.

Good economic policy is not about a set objective for a level of interest rates, or for a particular budget balance in any particular year. Interest rates always have and will go up and down. The budget balance will always swing between deficit and surplus. We are now in low interest rate, budget deficit position because economic growth is below trend. This is entirely appropriate.