2 August 2016
By Stephen Koukoulas
In the dismal science of economics, the Reserve Bank of Australia has failed dismally when it comes to its inflation target and managing demand in the Australian economy.
On Tuesday it cut official interest rates to 1.5%, but in doing so it leaves the Australian economy condemned to some of the highest interest rates in the industrialised world. The RBA has not looked all that closely for overseas guidance – this latest cut comes years after the US, the eurozone, Britain and Canada set interest rates at 0.5% or less.
This harsh assessment of the RBA’s slow and cumbersome approach to interest rate cuts is backed up by several vital macroeconomic indicators.
The annual increase in the consumer price index has been below 2% – the bottom of the RBA target band – since late 2014. There is no evidence in recent data that inflation will pick up any time soon.
The unemployment rate in Australia is the same as it was at the depths of the global financial crisis. This extraordinary lethargy in the labour market has occurred simply because the economy has been too weak to create enough jobs to lower it.
The industrialised countries that crashed into recession during the GFC all have lower unemployment now than their GFC peak levels, in part due to the super-stimulatory effects of lower interest rates and in many cases quantitative easing from their central banks.
To be sure, the RBA could not fully insulate the economy from the slump in the terms of trade and softness in economic growth in Australia’s major trading partners. But had it cut interest rates earlier and more aggressively, say having rates at 1% or less a couple of years ago, the Australian economy would be stronger with inflation higher and unemployment lower than is the case now. Part of this story would have been achieved with a lower Australian dollar.
The RBA has expressed concern about the boom in house prices in some cities and this may have been a factor in its reluctance to cut interest rates. Even this was something of an own goal from the RBA in terms of its management and policy response to what was an obvious imbalance in the housing market.
Despite the obvious benefits of tackling the house price boom with regulatory and macro-prudential policy changes, for many years the RBA resisted the push to take steps to tacking the house price boom with non-monetary policy measures. As a result, interest rates were kept too high for too long and it was only 18 months ago that the RBA reluctantly chose to implement a range of strategies to limit lending for investors.
The monetary policy errors of the RBA appear to be linked to its unduly optimistic outlook for the economy. As a result of this “glass half full” attitude to the economy as the outgoing RBA governor, Glenn Stevens, prefers, it failed to forecast the pace at which inflation has fallen. To be fair, the RBA was not alone in this error, with the market consensus over the bulk of the past few years skewed towards forecasting a pick-up in growth and with that, inflation remaining within the target range.
Over many years, other central banks around the world have been more proactive than the RBA in using monetary policy to stimulate and reflate their economies. Zero interest rates were unimaginable not that long ago, let aloneÂ quantitative easing and negative interest rates. Yet these policies dominate the industrialised world and the benefits of such policy settings are showing up, albeit very slowly, in news of better economic conditions and lower unemployment rates.
The end point is that the RBA has missed its inflation target and has failed to lead the argument that this is not acceptable. It has also been very slow to change its policy tack to reverse the pernicious effects of disinflation. The odds of inflation breaking out above the top end of the target range at the moment seems so low that more aggressive monetary easings are needed. Only then can it have confidence that inflation will move higher.
Unless there is a rapid about-face in economic conditions and with that, some upside to the inflation outlook, the RBA will eventually cut interest rates again. For the sake of at least of few of the 730,000 people unemployed and the credibility of the inflation target, it seems it should have done it a lot earlier.