Douglas Adams’ brilliant comic farce The Hitchhiker’s Guide to the Galaxy describes Earth as residing in sector ZZ9 Plural Z Alpha, one of “the uncharted backwaters of the unfashionable end of the Western Spiral Arm of the Galaxy” and being inhabited by “ape-descended life forms” who “are so amazingly primitive that they still think digital watches are a pretty neat idea”.
Sometimes when I return to Australia, I feel that I’ve arrived in the planet’s sector ZZ9 Plural Z Alpha. Here the economic debate is so primitive that people still think the economy can be controlled by tinkering with the rate of interest.
Is inflation rising? Then put the rate of interest up one and a half times as fast as inflation is increasing. Is output falling below trend? Then drop the rate of interest by half as much as output has fallen. Then adjourn for drinks.
This formula, known as the Taylor Rule, was all the rage in Central Banks from the early 1990s until the mid-2000s. Economists were so confident that they had economic management nailed that they invented the phrase “The Great Moderation” to describe the Goldilocks state of the economy, and took credit for bringing it about:
The sources of the Great Moderation remain somewhat controversial, but as I have argued elsewhere, there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy (Bernanke 2004, emphasis added).
Then in late 2007 the world went to hell in a handbasket when the global financial crisis began. Mainstream economists were forced to abandon the belief that getting the rate of interest right was all that was necessary to keep the economy on an even keel. Instead, the rate was dropped to near-zero to in an attempt to stop the economy sinking below the waves.
The USA? A cash rate of 0.13 per cent. Japan? 0.1 per cent. Europe? 0.25 per cent. The UK? 0.5 per cent. No-one asks what the central bank will do to interest rates at its next meeting at one of those more fashionable sectors of this planet, because the conceit that the central bank can fine-tune the economy by varying its interest rate is long dead.
Figure 1: Cash rates around the world.
But not in Australia. Here, what the Reserve Bank will do to the interest rate at its monthly meeting is big news. And because it’s big news, every month Sky News asks about 20 economists three (and lately four) questions about the RBA rates meeting on the first Tuesday of the month:
1) Do you expect the RBA to move on Tuesday? And if so, in which direction and by how much?
2) Where will the official cash rate likely sit by the end of the calendar year?
3) One thing you're looking for in the RBA statement?
4) What do you THINK the RBA should do on Tuesday? (we're asking for your opinion)
The first question I’ve likened to betting on which cockroach will get outside a circle first in Changi prison; it’s just gambling. On the second, I’ve consistently called for rates to be lowered, because in my opinion the main impact of our high cash rate – compared to the USA, Europe, UK and Japan in Figure 1 – has been an overvalued dollar that has decimated Australian manufacturing.
On the third and fourth, since March of last year, I’ve added a call that the RBA to introduce loan to valuation ratio controls to stop a property bubble forming. (Strictly, APRA would make such a call, but if the RBA said jump, APRA would do it.)
My answer to Sky News’ poll in March 2013 was:
1) I think the RBA will hold, but if there is any move it will be down;
2) 2 per cent
3) Realisation that (a) the cash rate is the main factor keeping the Australian dollar overvalued and (b) it has to do something to stop a housing bubble forming if it lowers rates--for example, reintroduce a maximum level for LVRs of say 90%.
But that’s all so yesterday. For last week’s poll, I changed my answers in a rather radical way:
- 3.5 percent [1 per cent higher than today]
- Realisation that they are stuck with 4 competing goals: declining employment, rising inflation, a housing bubble and an overvalued dollar, and whatever they do with rates will stuff up at least 3 of those 4 things
- Introduce loan to valuation controls like those in NZ (via APRA), persuade the government to introduce limits on non-resident buying of properties, raise rates by half a percent to help burst the property bubble they've allowed to develop.
The answers were partly in exasperation, since the whole idea that all the Reserve Bank can and should do to control the economy is vary the interest rate is nonsense. I felt rather like Ford Prefect, livid at the inability of the Golgafrinchans to design the wheel:
‘And the wheel,’ said the captain . ‘What about this wheel thingy? It sounds a terribly interesting project.’ ‘Ah,’ said the marketing girl, ‘well, we’re having a little difficulty there.’ ‘Difficulty?’ exclaimed Ford. ‘Difficulty? What do you mean, difficulty? It’s the single simplest machine in the entire Universe!’ The marketing girl soured him with a look. ‘All right, Mr Wiseguy,’ she said, ‘you’re so clever, you tell us what colour it should be.’
So I answered that the colour should be “square”. And, by analogy, the interest rate decision is about as useful as a square wheel in controlling the economy. There are at least four factors the RBA should care about, and they’re giving conflicting signs:
- The economy: this has been heading down for some time, and is still generally heading down—which indicates that rates should be cut. So tick the 'down' box.
- Housing: We now have a housing bubble because of the RBA rate cuts since 2012—rate cuts that it didn’t expect to make since against its expectations, the economy has been going down (check Figure 1 again: the RBA was alone in raising rates from 2010 since it falsely thought that the economic crisis was over and inflation was about to rise once more). Since the RBA has been and remains too gutless to introduce prudential controls on mortgage lending—unlike the New Zealanders, who did so in August 2013—then it should put interest rates up to prick the housing bubble. So tick the 'up' box.
- The currency: this has been overvalued for the last four years, thanks to our high interest rates, and though it’s fallen it is still above the RBA’s comfort level, let alone where the actual economy needs it to be (around 70 cents in my opinion). So tick the 'down' box.
- Inflation: though this has been consistently lower than the RBA has expected, it is now potentially moving up because the currency has fallen. So tick the 'up' box.
That gives us two “up” signals and two “down” signals. So what to do? Sit on our hands, or stay in a bath for 5 years, like the captain of the Golgafrinchans.
Bugger that, I thought. The one thing the RBA has done courtesy of its primitive belief that interest rates alone can control the economy is allow a housing bubble to form once more. So let’s prick that – hence my call for a 3.5 per cent rate by June 30 (this month’s question asked for the rate by the end of this financial year).
Of course, if the RBA did that – which it won’t – then the currency would fly back over a dollar for sure. There’s no way I actually thought that would be the rate. But please, let’s stop being digital watch fans, and join the rest of the world in realising that there’s more to managing the economy than tinkering with the rate of interest.
Now I think I’ll go have a drink with Marvin…