Saturday, August 04, 2007

Saturday Forum: Mersey Money - John Howard hands the Reserve Bank the final straw.

Whatever remaining hope there had been that Australia’s Reserve Bank might not push up interest rates when it meets next week vanished at 5.00am on Wednesday.

That’s when someone in the Prime Minister’s office uploaded onto YouTube an announcement that would change the dynamics of the election campaign, potentially redefine federalism, and along the way ensure that next Wednesday’s hike in interest rates became even more of a done deal.

In his webcast Mr Howard said that he had tried to co-operate with state Labor governments “for years but it simply hadn’t worked”. The state Labor government planned to close the Mersey Hospital in North West Tasmania. To stop them he would fund it himself.
It was, as he conceded, “not something the Commonwealth has normally done in past”...

The amount of money was small in relation to total Commonwealth spending – an extra $40 million or so per year. But it sent a signal. The Prime Minister said if the direct funding worked, “it could be a model for keeping viable hospital facilities in other parts of regional Australia”.

John Howard had opened the floodgates. His Health Minister Tony Abbott was besieged by requests to put up the funds to keep open other state government hospitals. His Education Minister was quoted saying she might put up the funds to keep open state government schools.

The Prime Minister had not only given new meaning to the phrase “opportunistic federalism”, he had also expanded the areas in which an electorally desperate Commonwealth government could extend its spending, apparently without limit.

What is there now to stop him intervening to restore Canberra’s cut ACTION bus services? What is there to stop him reopening some of the closed ACT schools? What’s to stop him rebuilding the closed Royal Canberra Hospital? Nothing it seems, except in Canberra’s case for the fact that neither of our electorates is marginal.

Importantly the new commitments that the Prime Minister now feels able to make will be ongoing. It will cost at least $40 million each and every year to keep the Tasmanian hospital going. As the Prime Minister assured listeners to AM on Thursday, “this is an exercise in providing additional money”.

Preparing to put the finishing touches to the recommendation on interest rates to be put to next week’s board meeting, senior staff at the Reserve Bank would have choked on their corn flakes.

We don’t know what was in the report sent to board members on Thursday, but it would already have included mention of retail spending (“on steroids” in the words of one private sector economist), credit (“turbocharged” in the words of another), business investment (growing faster than at any time since the 1960’s), home building and home prices (both climbing again.)

And consumer prices. Despite last year’s three hikes in interest rates inflation is heading back towards the top of the Reserve Bank’s target band and is set to climb above it.

On one reading it has already done so. The TD Securities – Melbourne Institute inflation gauge tracks prices month to month rather than quarterly as do the official figures. The latest, released on Friday, suggests that Australia’s underlying annual inflation rate climbed to 3.1 per cent in July, climbing above the reserve bank’s 2 to 3 per cent target band.

The breakout appears to be widespread. The Institute says in July prices rose in 45 spending groups and fell in only 10 – “by far the largest net balance of price rises ever recorded in the history of the gauge”.

Joshua Williamson of TD Securities has noted that the apparent pick up in inflation in July coincided with the delivery of the income tax cuts promised in the budget. He has told his clients that “given that consumer demand and confidence have been so strong, there is some suspicion that prices were pushed higher as firms took advantage of more favourable consumer finances”.

The tax cuts will pump $31 billion into the economy over the next four years. The Reserve Bank learned from this week’s YouTube announcement that the Prime Minister is prepared to pump in an untold amount more.

By itself John Howard’s Wednesday announcement would not have sparked a hike in interest rates. The Reserve Bank has learned not to get too excited about the promises made in the lead up to elections. The Governor Glenn Stevens told a parliamentary committee earlier this year that they often weren’t delivered in full and they are usually paid for by extra revenue.

The tax cuts delivered in July were funded in part by a booming economy and in part by a more efficient tax system. Some of the money handed to consumers in July would have once been there’s anyway.

But added to a climate in which the Reserve Bank was already concerned about runaway inflation the YouTube announcement is likely is likely to have strengthened its resolve to act.

Potentially holding the bank back is concern about a worldwide economic downturn and a dive in worldwide international share markets.

It happened this week, but the damage wasn’t severe.

The Australian share index fell back to where it was in April. Prices are still more than double where they were in 2003. The US share index has also fallen back to where it was in April. Its prices are somewhat less than double where they were in 2003.

There is a lot of concern about further damage to the US economy and through it further damage to worldwide economic demand, but there are unlikely to be dramatic developments before the Reserve Bank’s board meeting on Tuesday, and at the moment there is every sign that the Australian economy is resilient enough to withstand them.

Australia has benefited more than any other country from the China-centred worldwide economic boom.

Since 2001 our terms of trade - the prices we are paid for our exports relative to the prices we pay for our imports - has soared 37 per cent. Only one other country, petroleum-rich Norway has come close. Its terms of trade have soared 33 per cent. Canada, in third place, has had a terms of trade boost of 13 per cent.

Consumer confidence is at a near-record high and the arrival of the budgeted tax cuts and the election promises not yet announced are set to keep it high.

The Reserve Bank has no reason to believe that a hike in rates next week will do much harm, and every reason to fear that without one, it’ll lose control of inflation.

A hike in rates in August, should the board believe it to be justified, would also powerfully demonstrate the Reserve Bank’s independence. When asked earlier this year whether a looming election would stop the bank hiking in August if it felt it had to Glenn Stevens replied: “The answer to the question is if in August it needs to be done, it will be done.”

The Prime Minister may well have factored a hike in to the political calculus that lead to the budget tax cuts and Wednesday’s YouTube announcement.

The tax cuts will benefit all households (unusually for the government these ones benefit those at the bottom of the income scale as well as those higher up). The hospital announcement also holds out the prospect of benefits to all Australian households.

By contrast another interest rate hike (the fifth since the last election) might be seen to only directly hurt those households with mortgages.

Despite all the talk about mortgages in the media and elsewhere an astonishing 63.5 per cent of households don’t have one. They either own their homes outright or rent.
This isn’t to say that an interest rate hike won’t bite more broadly. It’ll feed into rents (perhaps quickly in the present market) and it could cut the value of the homes that are owned outright, as well as pushing up credit card interest rates.

But the immediate pain might be seen as limited. Only the mortgagees on variable rates are guaranteed to feel it before the election. The rest of us might be paying more attention to our tax cuts and the other election largess.

It is easy to quantify the pain for borrowers. Anyone on a $400,000 mortgage paying the standard variable rate would be up for about an extra $60 per month, taking their monthly payments to more than $300 per month more than they were at the time of the 2004 election.

They might well feel misled. In 2004 John Howard campaigned from a lectern that read “keeping interest rates low”.

It was a promise that in a literal sense he was unable to keep. The Prime Minister can not control interest rates, as the Reserve Bank is likely to make clear next week.

But in a deeper sense it is a promise that John Howard has decided not to keep.
Had low interest rates really been his number one priority he wouldn’t have budgeted to pump an extra $31 billion into an already turbocharged economy. And he wouldn’t have gone on YouTube holding out the prospect of more money, for everything, where needed, without limit.