Tuesday, May 20, 2008

Rate hikes: Just when you thought it was safe to go back into the water

A further interest rate hike is back on the agenda following a surprise revelation that the Reserve Bank board discussed pushing up rates at this month's meeting and a call from the head of the Treasury for the Bank to take tough action against inflation.

The minutes of the Reserve Bank's May 6 board meeting released yesterday confirmed that, as had been believed, the Bank's executive recommended that the board keep rates steady in May because consumer confidence and spending were weakening.

However they also reveal that despite this board members at the meeting “spent considerable time discussing the case for a further rise in the cash rate”.

An interest rate rise in May would have been the Bank's fifth since August...

...and would have taken the cash rate to 7.5 per cent and mortgage rates to more than 9.5 per cent.

The minutes say that on balance the board “decided that it was appropriate to allow the current setting of monetary policy more time to work”.

They added that “should demand not slow as expected or should expectations of high ongoing inflation begin to affect wage and price setting, the stance of policy would need to be reviewed”.

The account of the meeting, taken as preparing financial markets for the possibility of a further rate hike, sent the Australian dollar soaring above 96 US cents for the first time since 1984.

The dollar hit a 24-year high of 96.16 US cents shortly after the release of the minutes and remained above 96 US cents at the Australian close of trade.

The Bank's message was backed up the head of the Treasury Secretary Ken Henry who used a post-budget address in Sydney to aggressively defend the the Bank's role in raising interest rates in order to fight inflation.

Referring to critics of the Bank's actions, who include the Shadow Treasurer Malcolm Turnbull, as “seriously misguided” Dr Henry said that the Reserve Bank would not be successful in controlling inflation if its methods were “put aside the moment they are tested”.

Mr Turnbull has argued that a good deal of inflation “oil prices, food prices” comes from outside Australia and is not amenable to control by interest rates. Much of the rest comes from housing costs which he says are made worse by interest rate hikes.

Dr Henry said there was “no reason to think” that the Bank could not restrain the effects of higher world food and energy prices through the use of interest rates.

Properly understood, those outside factors were “demand shocks” whose effects could be contained by interest rates, not supply shocks beyond the bank's control.

Dr Henry's remarks are significant because in addition to being Secretary he is one of the nine members of the Reserve Bank board. It is unclear whether he represents the Treasurer on the board or is able to vote as he sees fit.

The board minutes do not identify the names of the members who speak at its meetings and so do not make clear whether Dr Henry was one those arguing for a further interest rate hike in May.

Dr Henry described the role of budgetary policy was less important than monetary policy in controlling inflation although it could have a role to play.

He said that the government's Budget had allowed “the so‐called automatic stabilisers to work”, which is taken to mean that the Budget was broadly neutral in its impact on inflation, neither pushing it further up nor doing much to bring it down.

He also took a swipe at the Coalition for its “Soviet style” stance opposition to market pricing for water, and for its obstruction to full road user charges for trucks.

The day after the Budget the Opposition used its Senate majority to block a regulation that would have increased the road user charge incorporated in the diesel excise.


“This should have been front page news. But it wasn’t. In fact, I have been able to find only one reference to it in the nation’s print media: a tiny side‐bar piece,” he said.

“The road user charge for heavy vehicles is not the most important structural policy matter likely to confront the nation's parliaments this year. But it would be one of the easiest.”

“If this terms-of-trade boom is going to have a happy ending, we are going to have to do better than this – a lot better.”

1 comments:

Fred Argy said...

Peter, thanks for your forthright front page story on Ken Henry’s speech. The headline paragraph (not I suspect your fault) is a little misleading: Henry is not necessarily arguing for further increases in interest rates so much as defending the logic of raising rates at a time when much of the inflation is imported.

He is not denying that higher prices of fuel and food are feeding indirectly – as well as directly – into domestic consumer prices (including the “underlying” rate of inflation) but the main point he wants to make is on page 8 viz. “It is the case that commodity prices are increasing, that price increases may be feeding into domestic consumer prices (though the evidence for that is weak) and there is nothing the RBA can do to affect global demand and supply. But these observations do not constitute a case for discarding our inflation targeting regime”.

In particular Henry is saying three things:
- that monetary policy is “helping to dampen” the imported inflation mainly through its secondary impact on exchange rates, price expectations and wage demands;

- “what remains reflects a positive demand shock” stemming from the terms of trade boom; and

- “there is no reason to think it is the sort of shock that cannot be accommodated by the sensible implementation of our inflation targeting framework”.

One could argue about the extent of “dampening” that is occurring at present as a result of the high dollar and the relative importance of demand and supply shocks that remain.

But I have no problem with the third proposition at all: we don’t need to abandon the current inflation targeting regime (on average over the business cycle). Clearly Henry is targeting those critics who want to see a change in the 2 to 3% target range. I myself have argued that the present regime gives the RBA plenty of flexibility in dealing with various forms of inflation and all that is needed is a cool head and patience in responding to the hiccup in inflation (much of it supply-side driven). See for example my recent Club Troppo piece on “who should we blame if unemployment rises?" http://www.onlineopinion.com.au/view.asp?article=7372

I remain skeptical of the need for further interest rate rises. For heaven’s sake let’s wait and see until later in the year – given the uncertain economic environment and the long impact lags associated with monetary policy.

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