Sunday, January 20, 2008

Saturday Forum: The wisdom of Stevens

Not certain which way our economy is heading? Relax. You are in esteemed company. And spare a thought for the man who’s required to have an opinion and act on it when his board meets Tuesday fortnight.

Our Reserve Bank Governor Glenn Stevens shared his thoughts on the economic outlook with a business audience in London Friday night.

His conclusion: “At the moment we do not know.”

Yet on Tuesday February 5 he’ll have to make a decision. He’ll have to either decide to push interest rates up, potentially deepening a spreading financial crisis, or to leave them where they are in the face of inflation already running out of control.

If he is looking for guidance he’ll find none in the pages of our newspapers. The headlines alternate between news of a share market collapse and an economy so exuberant it can only be reigned in by higher rates...

Tuesday February 5 is highly significant. It’s first Reserve Bank board meeting for the year and the first after the quarter inflation figures due for release this Wednesday. All but 2 of the past 10 consecutive hikes in interest rates have been decided at the meeting immediately following a quarterly inflation result.

The decision-making process has seemed pretty automatic.

The Bank’s inflation target, set down in a formal agreement with the Treasurer, is to keep the annual rate of between 2 and 3 per cent.

The so-called “headline” rate of inflation reported by the Bureau of Statistics, sometimes high, sometimes low, doesn’t matter to the Reserve.

It concentrates on what it calls its “core” measure of inflation, designed to exclude prices that jump around.

If its quarterly core measure exceeds 0.8 per cent - enough to push the annual rate above 3 per cent - it pushes up rates.

If the core rate is 0.7 per cent or below, the Bank usually leaves rates where they were.

Usually. But right now things are anything but usual. The Reserve Bank is also charged with maintaining the stability of Australia’s financial system.

At the moment our financial system is unstable. Our share index has just fallen for 10 consecutive days – its longest losing streak in twelve years. $150 billion has been wiped off the value of Australian stocks – 15 per cent since November.

Several Australian financial institutions have all but folded, among them RAMS Home Loans lift high and dry by the worldwide shortage of finance. Shares in the Centro Property Group are down 90 per cent. Yesterday the share price of the property and tourism investor MFS plunged 70 per cent. Even the share price of the Macquarie Bank has fallen 10 per cent.

Australia’s consumer banks are surviving but in order to do so they have sharply pushed up their interest rates. And not just by the well-publicised 0.2 per cent or so they have added to their variable mortgage rates. They have pushed up other rates charged to businesses steeply.

When finance is becoming hard to get and when private banks are increasing interest rates of their own volition the argument for the Reserve Bank to push up rates even further, making finance even harder to get, becomes less convincing.

Private sector economist Rory Robertson worked with the Bank’s current Governor Glenn Stevens in the Bank’s research department in the late 1980’s.

He says that like him, Glenn Stevens would remember well that by pushing up rates too high in 1989, the Bank “inadvertently put its fingerprints” on what turned out to be the early-1990s recession. Inflation did fall but the unemployment rate soared to 11 per cent. One million Australians lost their jobs, something the Bank and its political masters have never lived down.

“Looking back, if the Bank had hiked a bit less aggressively in 1989 - and instead simply had waited - the global recession of the early-1990s ultimately would have delivered the inflation-dampening slowdown the Bank was gunning for.”
“Governor Stevens may hike again anyway, but you can bet the Reserve Bank’s fingerprints on Australia's early-1990s recession will be in the back of his mind as he mulls the policy options ahead of the 5 February Board meeting,” he says.

Robertson says there’s nothing for the Bank to gain by hiking rates after next week’s consumer price figures as it normally would.

(So wedded has been the bank to its post-CPI tightening schedule that it made history in November by hiking during the election campaign, because that’s what the consumer price figures told it to do.)

Global share prices have collapsed 8 to 10 per cent in the last few weeks, the United States is near recession and the international financial system may seize up.

“It's unknowable, but if the world is going to financial hell, the Bank will do best if it remains on-hold next month. Conversely, if the world actually is not going to hell, we won't know it as early as 5 February.”

Others disagree. Both Westpac and the ANZ are predicting an appalling consumer price result on Wednesday. They expect the Bank’s core measure of inflation to come in at 0.9 per cent for the quarter – 3.4 per cent for the year – “a doozy!” in the view of the ANZ’s Mark Rodrigues.

Westpac Bill Evans says it’s territory the bank has never been in before in the two decades that it has been targeting inflation.

“We don't expect there would be too much debate around the Reserve Bank board table,” he says.

Mark Rodrigues says nearly everything points to still higher inflation in the 18 months ahead. Food, rents, petrol, retail prices flowing from spending spurred on by higher employment and resource-boom induced wage rises.

He says to not hike when it is clear that the Reserve Bank’s target will be exceeded for the next 18 months could “only be interpreted as a breach of the target”.

The Bank has given both the Prime Minister and the Treasurer the impression that it will hike if core inflation is high next Wednesday. Mr Rudd and Swan left Tuesday’s meeting with the Bank Governor ashen-faced declaring that interest rates were under pressure and that they for their part would do all they could to restrain government spending.

The Treasury has told Mr Swan that it has bumped up the inflation forecasts in its pre-election Mid-Year Review, but has not much changed its view of the broader economic outlook, suggesting that it is more worried about inflation than it is a worldwide slowdown or financial turmoil.

And overnight in London Governor Stevens mused that if his Bank did not act against inflation when it knew it was rising it might itself cause a crisis.

“I would venture that the tolerance among some parts of the investment community for a cautious approach by policy is not high, if some of the commentary we read is any guide,” he said.

“Were trend inflation to rise as a result of too-ambitious an approach to supporting short-term growth, financial prices would actually be among those most vulnerable to adjustment as long-term interest rates rose,” he concluded.

But the financial turmoil emanating from the United States worries him deeply. He believes that a worldwide economic slowdown caused by a recession in the United States is the least of the concerns.

The bigger danger is a “common shock” where a number of credit crunches occur simultaneously around the globe as lenders of withdraw or charge much more for funds.

He says it hasn’t happened yet. Asian investors appear not to have been burnt or scared by bad loans originating in the US. But he says there is “no guarantee of plain sailing”.

He told the London audience that his “guess” was that China would cope with a slowdown in demand from the United States. It might even be welcome given the breakneck pace at which the Chinese economy had been growing.

Australia, being “abundantly blessed” with the mineral resources that China needed would continue to benefit from the growth in Chinese incomes already underway. It was pushing Chinese incomes “through those levels at which resource use intensifies”.

He said the prices at which Australia sells minerals to China looked as if they would climb higher still.

“If they do, Australia’s terms of trade, which have already risen by about 40 per cent over the past five years, would move higher still,” he said, referring to the “striking difference in confidence one encounters when traveling from the Pacific time zone to the European one”.

The Governor presents himself as a worried optimist about the year ahead. He has already demonstrated that if he believes that if he believes rates have to rise because inflation is on the move, nothing will stop him not even the presence of an election campaign.

But the choice he has to make in two week’s time is clearly one he would rather not have.

He turns 50 on Wednesday when the CPI figures come out. He’ll need all of his accumulated wisdom.