Stevens' ringing call on monetary policy

If the Reserve Bank were to cut interest rates today, it would be an admission that monetary policy, as we know it, is broken or that the economy, as we know it, is in much more trouble than most people currently think.

I don’t think the bank is willing to admit either, just yet, and so I do not think interest rates will move today.

Of course, I could be wrong. It comes down to whether you believe that the Reserve is capable of fine tuning the economy, or that monetary policy is, to some degree at least, made in the governor’s gut.

The ‘fine tuners’ in the crowd argue that recent low inflation numbers and lower jobs will feed into the Reserve’s model of the economy, revealing an economy slightly softer than previously thought and with less inflation pressure.

Ergo, one more interest rate cut may be all that is needed to hit the economic sweet spot and engineer an economic recovery back to usual levels.

In fact, this is usually how monetary policy does work.

All things being equal, the Reserve Bank board’s staff may have already done this and recommended to the board that it should cut interest rates.

But this mechanical view of the world ignores the fact that interest rates have already been cut by a dramatic amount – by 1.75 per cent over the past year and a half.

Standard variable rates, at about 6.45 per cent, are already substantially below their long term average of about 7.5 per cent.

Borrowers already have an incentive to borrow and online savings rates are below 5 per cent, meaning savers have an incentive to do something more worthwhile with their money and invest.

Interest rates work with a considerable lag, of up to 18 months, so now is the time you would expect to be seeing the impact of rate cuts.

And arguably, we are. House prices have fallen back a bit, but the recovery since the end of last year has been marked. The value of retail sales may be disappointing for retailers, as margins are squeezed, but volumes are at their strongest since before the GFC.

Australia’s debt laden households have enjoyed the benefit of lower interest rates and used them to pay off the mortgage faster. This should, in theory at least, bring forward the day on which they are prepared to spend more.

Is that day now?

For those inclined to a ‘monetary policy set in the guts’ view of the world, there is a good chance that the hoped for recovery in non-mining parts of the economy is already underway, we just can’t see it yet because our indicators are partial and lagged.

Only time will tell, and that is a major argument for the Reserve Bank to continue sitting on the sidelines until it is obvious whether enough has been done. Thursday’s jobs report will be a game changer after last month’s weak reading. So too will be capital expenditure figures due later this month.

These figures may show what economists dearly hope – that monetary policy does still work. That lower interest rates have encouraged non-mining businesses investment.

It is possible, however, that the economy is much weaker than we expected. That structural changes in the economy, including the high exchange rate, mean that more monetary policy medicine is needed to help the patient recover. The high Australian dollar appears a permanent feature of the economy, meaning a period of intense change as some business models are destroyed. Firms relying on exports or competing with imports are having a hell of a time and many will close.

Will enough new business models be created to fill the void? Banks do not report being overwhelmed with new business loan applications. Nor have they been particularly forthcoming with loans to business, preferring instead to live off the fat of their home lending.

Will the recovery in domestic spending at existing businesses be enough to offset this weakness in new job creation? Again, only time will tell.

If it is not, arguably interest rates will need to be much lower than they are to stimulate recovery. Cutting by a quarter percentage point today will not be enough to do the trick. Better to wait and then cut more aggressively.

To recap, the Reserve Bank board faces two possible worlds. In the first world, monetary policy is not broken and its rates medicine is already working, in which case further interest rate cuts are unnecessary.

In the second, structural changes in the economy including a high Australian dollar and lower business lending mean Australia is set for a prolonged period of below average growth. For monetary policy to be effective in this environment, extraordinary measures will be needed. Interest rates will need to be much lower – as low as during the global financial crisis. One cut today will be insufficient to do the trick.

So which world is it?

On the basis of available evidence, it is not clear the Reserve Board has enough information to know definitively. It may choose to wait, or it may view the inflation risk of making a pre-emptive strike as low.

We're about to find out.