Wednesday, November 08, 2006

Why Australia's Reserve Bank jumped

In tomorrow's Canberra Times.

What have we done to deserve yet another rate rise, the third this year?

The correct answer came, perhaps unwittingly, from a real estate agent I heard interviewed on Canberra radio yesterday.

He said that every time interest rates go up the buyers vanish for about a month and then return just as eager as they were before.

That is the phenomenon that has forced the Reserve Bank to pile on interest rate increase after interest rate increase.

The Bank has found that typically spending and borrowing are hit hard in the month after it hikes rates, but then the impact eases, although some impact continues to be felt for about a year.

What the Reserve Bank wants us to wind back our spending more permanently. Each time it has pushed up rates in an attempt to get that to happen, our spending has bounced back up. It is hoping that a series of successive rate rises will do the trick for good.

The Bank says in yesterday’s statement that just recently it has noticed encouraging “tentative signs of moderation in the demand for credit”, presumably as a result of its two recent rate hikes in May and August. But it notes that that nevertheless “the overall pace of credit growth remains strong”.

If spending and credit growth continue to remain strong a month or so after this latest increase the Bank will push up rates once again.

If necessary it will keep putting up rates until we get the message and wind back our spending and borrowing way that lasts.

If on the other hand this latest rate rise builds on the effect of earlier ones and does change our behavior in a lasting way it will most probably be the final rate hike for quite a while.

The Prime Minister said yesterday that he didn’t like rate hikes any more than did any borrower.

The Reserve Bank is less squeamish. It believes that the biggest contribution it can make toward ensuring that our record run of economic prosperity lasts is to stop our spending running ahead of what can be bought and pushing up prices.

If some of us need to get our fingers burnt in order to ensure that happens, the
Reserve Bank believes that is a price worth paying.

The Secretary to the Australian Treasury Dr Ken Henry took part in the Reserve Bank’s Melbourne Cup Day decision as a member of its Board. His Executive Director (Macroeconomic) Dr Martin Parkinson told a business audience in Sydney yesterday that the decision was needed because “you want to be very careful about letting the inflation genie out of the bottle”.

That’s the Reserve Bank’s fear - that if inflation drifted beyond its target zone it wouldn’t come back until there was a recession. And it doesn’t want one.