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The interest rate cut that wasn't

Stephen Kirchner | Business Spectator | 05 November 2012

If financial markets are any guide, the Reserve Bank is set to reduce official interest rates to some of the lowest levels since the early 1960s. But that does not mean that monetary policy is very easy. The nominal official cash rate actually tells us very little about the effective stance of monetary policy.

The interest rate that matters is the real, or inflation-adjusted interest rate. In real terms, the official cash rate is not especially low relative to historical experience. Recent cuts in official rates have simply kept pace with a moderating rate of inflation to keep the real interest rate broadly steady.

The nominal cash rate must move by more than the change in the inflation rate for monetary policy to have the desired influence on the economy.

Much of the time, the RBA is simply playing catch-up to changes in the inflation rate. Consideration of the real cash rate puts the excited commentary surrounding official interest rate announcements in better perspective.

The real interest rate also helps explain why the Australian dollar exchange rate has been resilient in the face of lower nominal rates. The exchange rate is a relative price and other countries have been easing monetary policy too. Australia’s real interest rates remain well above those in the US, leaving Australia an attractive destination for foreign capital inflows.

The official interest rate is also not the interest rate at which home-owners, consumers and business actually borrow. Those rates are market-determined and the financial crisis has changed the relationship between official, wholesale and retail rates.

The RBA pays close attention to the transmission of changes in the official rate to these market-determined interest rates. If this transmission is weaker than sought, the RBA can always do more to obtain the desired easing in credit conditions.

As the RBA indicated in its August Statement on Monetary Policy, these market-determined interest rates are only ‘a little below their medium-term averages.’ Credit conditions are not as easy as the official cash rate might suggest.

The only relevant measure of the stance of monetary policy is inflation. The late Milton Friedman often observed that low nominal interest rates are in fact indicative of tight monetary policy because they arise in a low inflation environment.

High nominal interest rates are likely to be symptomatic of high rates of inflation and thus easy monetary policy.

Nominal interest rates in Australia were high on the eve of the financial crisis because inflation was running at 5 per cent, well above the RBA’s inflation target. By contrast, inflation was running at a little over one percent on the headline measure for the year ended in June.

In the US, the nominal Federal funds rate is near zero, but the so-called ‘new market monetarists’ argue that US monetary policy is still too tight given that expected inflation and bond yields are very low.

Quantitative easing represents a change in the operating instrument of the Fed from the price to the quantity of money, but does not in itself tell us anything about the stance of monetary policy.

In an environment in which the demand for money has increased because of fear and uncertainty, a central bank that fails to at least accommodate that increased demand will find itself presiding over deflation.

Quantitative easing has been inflationary only in the sense of preventing deflation.

Federal Reserve Chairman Ben Bernanke is determined not to repeat the mistakes of his 1930s predecessors that were so ably analysed by Milton Friedman.

As Bernanke said on the occasion of Friedman’s 90thbirthday, 'regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.'

Concerns that the RBA might ‘run out of ammunition’ by reducing official interest rates to zero are misplaced. The Reserve Bank can also change its operating instrument from the price to the quantity of money if needed.

It is not hard to imagine scenarios for the world and domestic economy that might lead the Reserve Bank of Australia to also resort to unconventional monetary policy instruments.

Quantitative easing is not a panacea and the new market monetarists sometimes oversell its benefits. However, it is the right monetary policy prescription under conditions such as those in the US and does not deserve the bad press it has received in Australia and abroad.

Dr Stephen Kirchner is a senior lecturer in economics at the University of Technology Sydney Business School and a research fellow at The Centre for Independent Studies.