Vital Signs: does monetary policy work any more?


Richard Holden, UNSW

In its quarterly statement on monetary policy, released today, the Reserve Bank of Australia declared its preparedness to “ease monetary policy further if needed”.

This suggests the bank still thinks monetary policy – in this case lowering interest rates to stimulate the economy – could help “support sustainable growth in the economy, full employment and the achievement of the medium-term inflation target”.

But in the wake of the bank last month lowering the official interest rate to a record low and the current somewhat sad state of the Australian economy, many commentators have speculated that monetary policy doesn’t work any more.




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Is that right?

There are a number of variants of the “monetary policy doesn’t work” argument. The most basic is that the Reserve Bank has this year cut rates from 1.50% to 0.75% without any improvement to the Australian economy.

This is a textbook example of one of the classic logic fallacies known as “post hoc ergo propter hoc” (from the Latin, meaning “after this, therefore because of this”). Put simply, it assumes the rate cuts have had no effect and doesn’t account for the possibility things might have been worse had there been no cuts.

Things might have been even worse. We’ll never know.

It also ignores what might have happened if the RBA had cut sooner. Again, we can’t know for sure. It is possible, though, to make an educated guess.

When to cut rates

Had the Reserve Bank acted, say, 18 months earlier to cut rates, it would have signalled that Gross Domestic Product (GDP) growth was indeed lower than desired, the sustainable rate of unemployment was more like 4.5% than 5%, and most importantly that it understood the need to act decisively.

That would have sent a powerful signal.

It would also have ameliorated the huge decline in housing credit that pushed down housing prices in Sydney and Melbourne by double digits. That, in turn, would have prevented some of the weakening in the balance sheets of the big four banks that has occurred (witness this annual general meeting season).

All of this would have pumped more liquidity into the economy and put households in a much stronger position, likely leading to stronger consumer spending than we have seen.

Bank pass through

One gripe both the Reserve Bank governor Philip Lowe and federal treasurer Josh Frydenberg have had with the banks is their failure to fully pass through the RBA cuts.




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It is true there is a problem with banks not being able to cut deposit rates below zero, and as a result having less scope to cut mortgage rates, which are majority funded from deposits.

But there are, of course, other ways monetary policy can work. The leading example is quantitative easing (QE). This is where the central bank pushes down long-term interest rates by buying bonds. At the same time this expands the money supply, thereby adding some upward inflationary pressure.

There is little reason to believe such measures won’t work.

The power of free money

Perhaps paradoxically, the closer interest rates get to zero the more powerful those rates may end up being.

To put it bluntly, if someone shoves a pile of money into your hand and asks almost nothing in return, you’re likely to use it. In fact, you would be pretty silly not to.

Suppose your mortgage rate really goes to zero – as has happened in Europe.

You might decide to redraw that and spend the money on a home renovation or some other productive purpose. Or you might decide to buy a more expensive house.

Such spending provides an economic boost. The effect is all the more pronounced if people expect interest rates to be low for a long period of time. Aggressive cutting coupled with quantitative easing – which lowers long-term rates – signal just that.

But not only monetary policy

Just because monetary policy still has some effect at near-zero rates doesn’t mean we should pin all of our economic hopes to it.

A near consensus of economists have argued repeatedly for the use of more aggressive fiscal policy – including more infrastructure spending and more tax cuts.




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Indeed, Philip Lowe has raised eyebrows by speaking so forthrightly on this issue. That doesn’t make him wrong, though.

There is little doubt the Reserve Bank should have acted much earlier to cut official interest rates. There is also a very good chance it will need to begin to use other measures such as quantitative easing in the relatively near future.

All of that says the Australian economy, like most advanced economies around the world, is in bad shape.

But it doesn’t mean monetary policy has completely run out of puff.The Conversation

Richard Holden, Professor of Economics, UNSW

This article is republished from The Conversation under a Creative Commons license. Read the original article.

We asked 13 economists how to fix things. All back the RBA governor over the treasurer


Peter Martin, Crawford School of Public Policy, Australian National University

Thirteen leading economists have declared their hands in the stand off between the government and the Governor of the Reserve Bank over the best way to boost the economy.

All 13 back Reserve Bank Governor Philip Lowe.

They say that, by itself, the Reserve Bank cannot be expected to do everything extra that will be needed to boost the economy.

All think that extra stimulus will be needed, and all think it’ll have to come from Treasurer Josh Frydenberg, as well as the bank.

All but two say the treasurer should be prepared to sacrifice his goal of an immediate budget surplus in order to provide it.

The 13 are members of the 20-person economic forecasting panel assembled by The Conversation at the start of this year.

All but one have been surprised by the extent of the economic slowdown.




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The 13 represent ten universities in five states.

Among them are macroeconomists, economic modellers, former Treasury, IMF, OECD and Reserve Bank officials and a former government minister.

The Bank needs help

At issue is the government’s contention, spelled out by Frydenberg’s treasury secretary Steven Kennedy in evidence to the Senate last month, that there is usually little role for government spending and tax (“fiscal”) measures in stimulating the economy in the event of a downturn.

Absent a crisis, economic weakness was “best responded to by monetary policy”.

Monetary policy – the adjustment of interest rates by the Reserve Bank – is nearing the end of its effectiveness in its present form. The bank has already cut its cash rate to close to zero (0.75%) and will consider another cut on Tuesday.

It is preparing to consider so-called “unconventional” measures, including buying bonds in order to force longer-term interest rates down toward zero.




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Governor Lowe has made the case for “fiscal support, including through spending on infrastructure” saying there are limits to what monetary policy can achieve.

The 13 economists unanimously back the Governor.

Seven of the 13 say what is needed most is fiscal stimulus (including extra government spending on infrastructure), three say both fiscal and monetary measures are needed, and three want government “structural reform”, including measures to help the economy deal with climate change and remove red tape.

None say the Reserve Bank should be left to fight the downturn by itself without further help from the government.

There is plenty of room for fiscal stimulus, particularly infrastructure spending – Mark Crosby, Monash University

I agree with the emerging consensus that monetary policy is no longer effective when interest rates are so low – Ross Guest, Griffith University

It is time for coordinated monetary and fiscal policies to boost domestic demand – Guay Lim, Melbourne Institute

The surplus can wait

Eleven of the 13 believe the government should abandon its determination to deliver a budget surplus in 2019-20.

Renee Fry-McKibbin. Ease surplus at all costs.
ANU

Economic modeller Renee Fry-McKibbin says the government should “ease its position of a surplus at all costs”.

Former Commonwealth Treasury and ANZ economist Warren Hogan says achieving a surplus in the current environment would have “zero value”.

Former OECD director Adrian Blundell-Wignall says that rather than aiming for an overall budget surplus, the government should aim instead for an “net operating balance”, a proposal that was put forward by Scott Morrison as treasurer in 2017.

The approach would move worthwhile infrastructure spending and borrowing onto a separate balance sheet that would not need to balance.

Political debate would focus instead on whether the annual operating budget was balanced or in deficit.

Former treasury and IMF economist Tony Makin is one of only two economists surveyed who backs the government’s continued pursuit of a surplus, saying annual interest payments on government debt have reached A$14 billion, “four times the foreign aid budget and almost twice as much as federal spending on higher education”.

Tony Makin. Surplus needed for budget repair.
Griffith University

Further deterioration of the balance via “facile fiscal stimulus” would risk Australia’s creditworthiness.

However Makin doesn’t think the government should leave everything to the Reserve Bank.

He has put forward a program of extra spending on infrastructure projects that meet rigorous criteria, along with company tax cuts or investment allowances paid for by government spending cuts.

Former trade minister Craig Emerson also wants an investment allowance, suggesting businesses should be able to immediately deduct 20% of eligible spending.

It’s an idea put forward by Labor during the 2019 election campaign. Treasurer Josh Frydenberg has indicated something like it is being considered for the 2020 budget.

Emerson says it should be possible to deliver both the investment allowance and a budget surplus.

Quantitative easing would be a worry

Five of the 13 economists are concerned about the Reserve Bank adopting so-called “unconvential” measures such as buying government and private sector bonds in order to push long-term interest rates down toward zero, a practice known as quantitative easing.

Jeffrey Sheen and Renee Fry-McKibbin say it should be kept in reserve for emergencies.

Adrian Blundell-Wignall and Mark Crosby say it hasn’t worked in the countries that have tried it.

A quantitative easing avalanche policy by the European central bank larger than the entire UK economy has left inflation below target and growth fading. Quantitative easing destroys the interbank market, under-prices risk, and encourages leverage and asset speculation – Adrian Blundell-Wignall

Steve Keen says in both Europe and the United States quantitative easing enriched banks and drove up asset prices but did little to boost consumer spending, “because the rich don’t consume much of the wealth”.

The treasurer should step up

Taken together, the responses of the 13 economists suggest it is ultimately the government’s responsibility to ensure the economy doesn’t weaken any further, and that it would be especially unwise to palm it off on to the Reserve Bank at a time when the bank’s cash rate is close to zero and the effectiveness of the unconventional measures it might adopt is in doubt.

Measures the government could adopt include increasing the rate of the Newstart unemployment benefit, boosting funding for schools and skills training, borrowing for well-chosen infrastructure projects with a social rate of return greater than the cost of borrowing, further tax cuts that double as tax reform (including further tax breaks for business investment) and spending more on programs aimed at avoiding the worst of climate change and adapting to it.

The economists are backing the governor in his plea for help. They think he needs it.


The 13 economists surveyed




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The Conversation


Peter Martin, Visiting Fellow, Crawford School of Public Policy, Australian National University

This article is republished from The Conversation under a Creative Commons license. Read the original article.

Vital Signs. If needed, this man can and will cut rates during the election campaign


Richard Holden, UNSW

It was a great story.

Philip Lowe had taken over as Reserve Bank governor after 25 years of uninterrupted economic growth. The Australian economy was transitioning nicely away from the country’s biggest-ever mining boom. Interest rates had been cut to historic lows in the wake of the 2008 financial crisis and had bottomed out. Inflation and wages growth were about to pick up. Unemployment was falling. And the new governor would preside over a return to “new normal”, with gradual rate rises up to a cash rate of 3.5-4.0%.

Then a funny thing happened on the way to the fairytale ending.

In a remarkable speech at the National Press Club on Wednesday, Lowe essentially admitted that the bank might well need to take extra remedial action to get the economy moving again.

Gone was the mantra that “the next movement in interest rate will likely be up”. Rather, Lowe said:

…here are scenarios where the next move in the cash rate is up, and other scenarios where it is down. Over the past year, the next-move-is-up scenarios were more likely than the next-move-is-down scenarios. Today, the probabilities appear to be more evenly balanced.

Translation: “I don’t want to freak you out, but we’re probably going to have to cut rates. And do it sooner rather than later.”

Consider the two main things driving the Reserve Bank’s decision.

Inflation is stubbornly low. As I pointed out last week, the bank has long had an inflation target of 2-3%, but it keeps undershooting it, and not just missing the centre, but missing the lower bound. In two and a half years with Lowe as governor, inflation has averaged just 1.87% – and has never been inside the target band. The latest figure is 1.8%.



Related to that, wages growth is anaemic. For five years it has barely kept up with inflation.

This is broadly true in advanced economies around the world (although our wages are doing worse than those in the United States) and suggests the unemployment rate will need to be pushed down further than in the past in order to reignite wages pressure and hence inflation. That suggests we’ll need even lower interest rates than we’ve got in order to provide what the boffins call monetary stimulus.



And the Reserve Bank’s cash rate — the rate that most other rates are set in reference to — is already the lowest on record, at just 1.5%.

Meanwhile, the housing market has taken a big hit, which isn’t over. Nationwide, the market is down 6.1% from its October 2017 peak. In Sydney and Melbourne, the falls are double that.

They are the mainly the result of a credit crunch that flowed from the Australian Prudential Regulation Authority’s decision to wake from its multi-year slumber and tighten lending rules at about the same time the banks responded to the royal commission by impersonating frightened turtles.

Sinking property prices sink spending

Sliding property prices shrink household spending, which makes up roughly 60% of economic activity.

On Tuesday, in the statement it released after its first board meeting for the year, the bank obliquely signalled that it had cut its GDP growth forecasts, mentioning forecasts of 3% this year and less in 2020 instead of the 3.5% this year and less in 2020 it had mentioned after its December meeting.

Add in the global headwinds from the US-China trade tensions and the fallout from the bungled Brexit, and it’s hard to find much that’s encouraging about the Australian economy in the year ahead.

Lowe didn’t want to state explicitly that he might have to cut rates between now and the election (and if necessary during the campaign itself), but he didn’t need to. He has been as clear as governors get.

Rates could be cut on budget day

A decent bet is the bank will cut 25 points on the first Tuesday in May, after the release of the updated (and possibly weak) inflation data on April 24.

Another possible date is the first Tuesday in April, April 2, after the March release of the December quarter economic growth figures, especially if economic growth turns negative. Coincidentally, April 2 is the day the government has set aside for the early budget, so it can hold the election in May.

If it does there will be some who will try to spin it as good news. In 2007 John Howard campaigned under the slogan that rates would be “lower under the Coalition”.

Don’t think it couldn’t happen

His treasurer Peter Costello was under the impression the bank wouldn’t dare move rate during the campaign, unwisely telling broadcaster Jon Faine it would keep them put.

“He looked me in the eye. He put his thumb down as he sat there…and he said, ‘There will not be a rate rise in November. Take it from me’,” Faine said.

Having marked out the territory, there is no doubt the bank will use it if needed. To do otherwise would be to invite questions about whether it had favoured one party or the other by holding off.

The hard truth is that we live in a secular-stagnation world, with too much saving chasing too few profitable investment opportunities.

Rates no longer need to be particularly high

That means that interest rates don’t need to be anything like as high as they once did to attract enough money to fund good ideas. And even if the ideas are good, it is likely they won’t need as much money as they did. Whereas once it took tens of billions of dollars to create a globally significant company (like BHP or US Steel) all it takes now is maybe $2,000 and a laptop, as with Facebook and Google.

A massive mining boom caused by the transition of China to a market economy and then a huge property bubble masked the new reality here for while.

Now it is here for all to see, the Reserve Bank governor included.




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The Conversation


Richard Holden, Professor of Economics, UNSW

This article is republished from The Conversation under a Creative Commons license. Read the original article.

Vital Signs. Yet another year of steady rates. What’s the point of the RBA inflation target?



File 20190131 112389 1ubj9ef.jpg?ixlib=rb 1.1
Economists expect the cash rate to remain steady for yet another year even though inflation is on the floor.
Shutterstock

Richard Holden, UNSW

The Reserve Bank kicks off its first meeting for the year next Tuesday facing the same dilemma it did throughout last year.

It hasn’t got easier.

The bank has a very public, fairly clear objective: to keep inflation between 2% and 3%. But it keeps missing it. Over and over and over again, and on the downside.

As the following chart shows, inflation has been below the bank’s target band for nearly all of the past four years.



During his decade in office, the previous governor Glenn Stephens achieved an average inflation rate of 2.46% – almost bang in the centre of the target band.

During his subsequent two and half years in the job, Philip Lowe has averaged just 1.87%. At no point during Lowe’s term of office has the average fallen within the target band. The rate for December, released on Wednesday, was 1.8%.

Next Wednesday Lowe will make an unusual address to the National Press Club, during which he will outline his thoughts about the year ahead.

It is a year which The Conversation’s forecasting panel predicted will be free of interest rate adjustments, making it a record 40 months without a rate move – Lowe’s entire term in office.



The RBA has more than one target

Although the inflation target is an important part of the Reserve Bank’s mandate, it is also asked to focus on other things. Among them are GDP growth, employment, and (probably less explicitly) the Australian dollar and house prices.

And therein lies the problem. Unless the rate moves needed to meet all those objectives point in the same direction, the bank needs to make trade-offs, or sideline one or more of its objectives.

A classic principle of economics is that a policy-maker needs one instrument (or policy tool) for each objective. It is called the Tinbergen Rule, after the 1969 Nobel Laureate.

The bank has four or five objectives, but really only one tool – the cash rate, stuck at 1.5% since Lowe took the job.

Throw in the ability to partially shape market expectations through speeches by Lowe and Deputy Governor Guy Debelle (so-called “open mouth” operations), and maybe it has two.

Since Lowe took office, the casualty of this imbalance between instruments and objectives has been the inflation target. And it’s unlikely to change for some time.

So why is inflation so low?

Australia is not alone. Advanced economies around the world have had several years of low wages growth, low productivity growth, and low inflation. Populations are ageing, less keen on spending, and have a glut of excess savings.

Add to this the fact that technology and international trade have made a whole range of goods probably permanently cheaper and it’s hard to find inflationary pressure.




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Vital Signs: inflation misses again, so where does the RBA go next?


Potentially making things worse in Australia is the decline in house prices in Sydney and Melbourne eating into consumer confidence and with it, spending. With well over half of the economy coming from private spending, already soft consumer spending could be hit further.

So far, RBA Governor Philip Lowe has been doing an admirable impression of Mr Micawber, in the Charles Dickens novel David Copperfield. When it comes to inflation, he is hoping “something will turn up”. But it hasn’t, even with historically low levels of unemployment.

Worse still, it doesn’t even seem to really be ticking up in the United States, despite the lowest year-end unemployment rate since 1969.

And why does it target inflation?

The bank targets inflation in order to maintain credibility.

The high levels of inflation in the 1970s and ‘80s – despite quite high levels of unemployment – led to the realisation that expectations had a lot to do with it.

Put simply, if people believe prices are going to rise sharply they will demand steep wage rises, which will cause prices to rise sharply. It becomes a “wage-price spiral”.

Macroeconomists and central bankers realised that a credible commitment to keep inflation low would remove the need for the large wage rises, cutting off the spiral before it got going.

The bank describes the rationale for its inflation target this way:

The Governor and the Treasurer have agreed that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3%, on average, over time. This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private-sector inflation expectations.

That’s been the logic for the past 25 years. We have certainly done away with inflationary spirals. We are in the age of secular stagnation, with an excess of savings chasing too little spending. A world where, since the turn of this century, robust growth has only really been possible when accompanied with financial bubbles–first in dot-coms, then in housing.

So what’s a central banker to do?

There is an active debate among central bankers and leading macroeconomists about whether to abandon the inflation targeting framework.

Luminaries like former US Treasury Secretary Larry Summers argue that inflation targets are, to borrow from Hamlet, “more honour’d in the breach than the observance”.

Right now Lowe faces a real dilemma. If he doesn’t cut rates, the inflation target will become more and more of a joke. It will add to pressure on him to articulate a new monetary policy framework for a new secular-stagnation era.

If he does, he risks re-inflating the housing bubble, boosting already sky-high household debt, and giving himself even less wiggle room if a recession hits.

On Tuesday he’ll leave the cash rate at 1.50%. And on the first Tuesday of the next month, and the the next, and the one after that…

But I think he’ll begin serious internal discussions about a new monetary policy framework, and the mechanics of getting into (and out of) a massive bond-buying program (otherwise known as quantitative easing or printing money) if needed to ward off the next recession should the cash rate remain or get so low he can’t cut it further.

He might have already started. He might drop further hints on Wednesday.




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The Conversation


Richard Holden, Professor of Economics, UNSW

This article is republished from The Conversation under a Creative Commons license. Read the original article.

Vital Signs: inflation misses again, so where does the RBA go next?


Richard Holden, UNSW

Vital Signs is a regular economic wrap from UNSW economics professor Richard Holden (@profholden). Vital Signs aims to contextualise weekly economic events and cut through the noise of the data affecting global economies.


The disturbing trend of persistently low inflation continues, as Wednesday’s data release shows.

Headline inflation was 2.1% for the last 12 months. But the more relevant “underlying” rate came in at 1.9%. This is even below the 2.0% the RBA forecast in May.

Given that the RBA’s target band for inflation is 2-3%, and that inflation has barely touched the bottom of that band over a protracted period, there are implications for monetary policy.

But, before we get to that, the obvious question to ask is: why is inflation so low?




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One strand of thinking involves the “Philips Curve”. This basically says that low unemployment pushes up wages growth and hence inflation.

We could get into a long discussion of whether the current 5.4% unemployment rate is “low”. And whether the effective rate really is 5.4% given anecdotal evidence about “underemployment”, the impact of recent decisions on penalty rates and minimum wage rises, and the robot revolution as a backdrop to the whole labour market.

But we don’t need to go there. There is barely any evidence of the Philips Curve in the data over the past quarter century, so let’s just reject that theory and move on.

Plausible factors keeping a lid on inflation

  1. Technology. The information technology and internet revolution has made lots of things much cheaper. Take music. Gone are the days of paying A$20-plus for a CD with maybe 16 songs on it. Streaming services like Apple Music and Spotify give access to literally millions of songs for a small monthly fee.

  2. China. The rise of Chinese manufacturing has led to everything from kids’ toys to cell phones being produced vastly more cheaply than if those things were manufactured with higher-cost labour.

  3. Globalisation and trade. The world has become radically more connected, and so have company supply chains. This not only allows access to lower-cost manufacturing but also leads to better specialisation through the principle of comparative advantage. This means that high-labour-cost countries like Australia can specialise in other components of goods and services, get better at producing those components, and reduce overall costs further.

  4. Wages. Wage growth has been subdued for a long time now. Since labour costs are an important component of many goods and services, this has served to tame inflation. One potential reason for low wage growth is that automation sits as a background threat to human labour. If labour costs get too high then processes get automated, which serves to keep wages in check.

  5. Leverage and consumer spending. A final factor is that given how heavily indebted Australian households are –largely through mortgage debt – they simply don’t have a lot of discretionary income. This limits consumer spending and makes price rises in the retail sector less likely.

These factors don’t look likely to change any time soon – with the possible exception of trade due to the Trump trade war. But even if that escalates dramatically it will shrink economic activity, further depressing prices.




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So we have long-run, persistently low inflation. Is that a problem?

The major concern is that it could turn into deflation, although that doesn’t look terribly likely right now.

If, however, there was another significant economic downturn then deflation is a very real prospect. That would raise the spectre of Japan’s experience of the 1990s where deflation caused people to hoard money, severely contracting economic activity.

But for now the real impact of low inflation is on the RBA.

Faced with inflation below its target band for an extended period, the standard response would be to cut interest rates. The RBA is clearly worried about doing this.

One reason is housing prices – the RBA is worried about further fuelling the bubble.

With housing prices easing, this may become less of a concern, although household debt levels remain extremely high. Not encouraging households to become further indebted seems like a reasonable concern.

A second reason the RBA may be nervous about cutting rates is that it doesn’t have very far to go with the cash rate at 1.50%. If there is another major economic downturn then the RBA wants to have some firepower left to respond.

If short-term rates were already near zero then the only tools available to the central bank would be non-standard measures such as quantitative easing. That would be uncharted territory for the RBA, which seems reticent to explore that territory.

So, as with economic growth and wage rises, the RBA response seems to involve crossing as many fingers and toes as possible and to publicly proclaim that things are looking good, but may take a while.

The ConversationWe will get a better look into how that strategy is going when wage price index figures are released mid-August.

Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW

This article was originally published on The Conversation. Read the original article.