Interest rates settings depend on forecasts of price inflation, wages and unemployment. There is now sufficient evidence to suggest that the Reserve Bank should begin to cut interest rates soon and arguably at its December Board Meeting. The balance of risks if it stays there much longer is that the economy will fall into a full recession.
For the last thirty years or so, in Australia, interest rates have been solely determined by the Reserve Bank (RBA), While there is provision in the Act for the Treasurer to over-ride the RBA’s decision, this has never happened.
The logic is that politically elected government ministers cannot be trusted to make the tough decisions required to maintain economic discipline. Instead, we are better to rely on independent experts. But how expert are they?
The inflation outlook according to the RBA
According to the RBA Governor, Michele Bullock, in her most recent speech (28 November), “there is still some way to go to return inflation sustainably [her emphasis] within our 2-3 per cent target range.”
As the RBA sees it, the headline inflation rate is not a good indicator of the sustainable inflation rate, because of the influence of temporary factors such as electricity rebates. Instead, the RBA focuses on the trimmed mean inflation which removes the impact of the outlying high or low price increases. On this measure the Governor considers that “inflation was still too high at 3½ per cent over the year to the September quarter” – the most recent information.
In addition, to focussing on an assessment of recent movements in consumer prices, the other variable that greatly influences RBA decisions is the tightness of the labour market.
The RBA is trying to walk what it calls a “narrow path” where it gets inflation back down to a sustainably low level within a reasonable timeframe, alongside a gradual easing of labour market conditions but avoiding excessive unemployment.
But according to the Governor, “Australia’s labour market conditions appear unusually tight.” The RBA’s fear is that if inflation is still too high and the labour market is still tight then the risks of setting off a wage-price spiral are unacceptable.
The Governor’s end conclusion therefore is that “Given the tightness in Australia’s labour market, along with our assessment that the level of demand still exceeds supply in the broader economy, we expect it will take a little longer for inflation to settle at target in Australia.”
This has led financial markets, who have to put their money where their mouth is, to generally interpret the Governor’s remarks as meaning that interest rates will not start to fall until around the middle of next year.
An alternative view
On the other hand, an increasing number of economists (including me) are coming to the view that interest rate cuts should start much sooner, and possibly as early as next week.
First, it is arguable that measuring the increase in prices over as long as the last twelve months is too long a time period. It can give a misleading impression of current inflation if the rate of inflation in say the second half of the last twelve months has been much lower.
For example, as Ian McAuley has pointed out in his newsletter, if we take the ABS consumer price index that excludes volatile items, then prices actually fell over the last three months ending in October, which is way below the target range.
Second, the RBA’s forecasting record has not been good. It has held inflation within its target range for only 15 months over the past 10 years. The principal problem has been a misreading of the labour market which the RBA sees as the principal driver of inflation.
Before Covid, between 2011 and 2019, the RBA persistently overestimated annual wage growth by about 1 percentage point as actual wage growth declined from about 4 per cent annually to around 2 per cent and only 1.4 per cent by 2020.
The RBA tried to explain this sluggish wage growth – less than they forecast – as being due to a fall in the rate of unemployment consistent with maintaining a low and stable inflation rate (the NAIRU). In the past, the RBA was on record as saying that the NAIRU was around 5 per cent, but eventually the RBA accepted that the NAIRU must have fallen.
At present it seems that the RBA now thinks that the NAIRU is around 4½ per cent. However, the RBA has never provided a proper explanation of why the NAIRU fell nor why it is still as high as 4½ per cent. Arguably the NAIRU today is significantly lower than 4½ per cent.
Nor has the RBA considered the possibility that the response of wages to any change in unemployment may now be less than in the past. The institutional arrangements for determining wages and the power of trade unions are very different from what existed at the time of the wage-price spirals back in the 1970s and 1980s. It is therefore likely that the risks of a wage-price spiral are today very much less.
After all, unemployment fell to a low of 3½ per cent last year and wage growth did not take off. Also, annual wage growth has averaged 3.2 per cent over the last three quarters, which is less than the RBA’s forecasts, and entirely consistent with price inflation being well within the Reserve Bank’s target range.
Third, the national accounts released by the ABS on Wednesday do not suggest that demand is outstripping supply in this economy. There was no growth in private demand, and for the seventh quarter in a row there was negative growth in per capita GDP.
Household incomes are clearly stagnant, and how the RBA can consider that is consistent with tighter labour market conditions than would in turn be consistent with low and stable inflation remains unexplained.
Fourth, the RBA says it is particularly concerned about ‘services inflation’ where the Governor says, “The underlying inflation rate that we’re experiencing is still sitting at around about 5 per cent.” But medical and dental costs, insurance and rents have been the key contributors, and it is questionable whether interest rate increases will help much to bring these price increases down. Indeed, insurance has been the biggest contributor to services inflation and those premium increases have been driven by the increasing risk of adverse weather events because of climate change.
Fifth, and finally, it is widely recognised that monetary policy changes only take effect with a lag. We cannot be sure how long these lags are – and they do vary from one cycle to another – but it seems that the balance of risks strongly favours starting to lower interest rates much earlier than the middle of next year. All other central banks have started to lower interest rates and have not waited until inflation is back in the target range.
Conclusion
The RBA’s poor forecasting record and especially its deficient understanding of the labour market has meant that it has established a track record of leaving its interest rate changes too late and arguably overshooting.
In the years before Covid, the RBA held interest rates too high for too long, despite evidence that wages were stagnant. When the RBA did finally recognise reality and cave in there were repeated cuts during 2019 with the RBA’s cash rate falling to the extraordinarily low figure of 0.1 per cent. And then the RBA infamously suggested that there would be no rate rises until 2024. However, that pronouncement was quickly blown out of the water with 13 rate rises over 2022 and 2023.
The RBA’s cash rate has now been at its current high point of 4.35 per cent for over a year, and the balance of risks if it stays there much longer is that the economy will fall into a full recession. Furthermore, inflation is coming down and that will most likely continue even if interest rates start to fall, given the lags before they really impact on incomes and spending.
In sum, the best outcome would be for the RBA to cut interest rates at its Board Meeting next week.