It’s the Future, Stupid!

Do the many people who interact in financial markets to determine interest rates, look at the rear vision mirror, through side windows or out the front? Experience and economic theory teach us that financial markets are dominated by expectations, not surprising because credit contracts relate to the future.

This fundamental insight appears to get lost in the current politicking over Australian interest rate increases. Playing the blame game is of course politically attractive for a newly elected government. No doubt, the fiscal largesse of both major political parties will influence future spending and saving and hence prospective inflation. But the key strategists –including in the Reserve Bank – whose market interactions result in interest-rate movements already look beyond the next year and beyond our national borders. Their expectations are strongly coloured by the massive increases in food and raw material prices. World prices for food and oil (in US-$ terms) are up more than 60 per cent on a year ago, all commodities by over one-third. These massive inflationary impulses have not yet worked their way through national price, cost and wage structures. In addition, US monetary policy is loose, the US budget is in deep deficit and the Iraq and Afghanistan wars are costing billions every month, reminding financial strategists of how Vietnam triggered world inflation a generation ago.

At times of great slack in the economy, inflationary impulses can be absorbed partly by spare capacities and unemployed workers, and price setters are cautious not to pass on all cost increases. Alas, as of 2008, there is not much slack around. Inflationary impulses can also be absorbed by productivity increases. Unfortunately, most Western economies have become weary of economic reforms that propel productivity improvements. Indeed, there is much hardening of the economic arteries through more and more political regulation, which leads observers to expect more passing-on of price and cost impulses. In Australia, we are confronted not only with the consequences of the inept labour-market reforms under Howard, but also with the re-regulation of labour markets under Rudd. We can expect union resistance to the erosion of real wages by rising fuel and food bills. Econometricians have come up with a clever artefact, the Non-Accelerating Inflation Rate of Unemployment (NAIRU), i.e. that rate of slack in labour markets which prevents inflation from accelerating further. Malcolm Turnbull recently had his moment in Parliament by drawing attention to it. What was missed in the mirth was that labour-market re-regulation will inevitably drive up that unemployment rate and nominal interest rates, because re-regulation leads to expectations of higher inflation.

Is there anything a responsible Australian government could do to mitigate this prospect? One obvious way would be to make labour and other markets more flexible, but the unions will not allow the Labor government to do this. Another is to lower the cost of imports by tariff cuts, such as of children’s’ garments, shoes and textiles, or of motor cars. Alas, the Rudd government has just announced that there will be tariff reviews outside the usual, objective Productivity Commission framework and with strong lobby participation. This is already fuelling expectations that there will be no relief for Australians from this inflation-fighting instrument. Nor can we expect relief from petrol excise reductions, so that the world oil inflation will hit home, directly at the bowsers and indirectly through inflation of all transport costs. Those who determine interest rates are already factoring these policy decisions of the Rudd government into their expectations.

For the time being, the Australian dollar is strong and provides a bulwark against some import price increases. But what will happen in the next recession when a weakening dollar adds to the other inflation impulses?

Financial strategists are also looking a little further ahead. Climate policies are already driving up cost levels. The present explosion of world food prices has much to do with political subsidies for diverting wheat and sugar from hungry mouths into fuel tanks. Interventions in energy markets to promote inefficient solar and wind devices also add to the inflation of energy costs. Politicians of a Green persuasion already talk cheerfully of petrol prices around $ 5 to curb private driving.

Various studies have been prepared by leading researchers for the US Congress on the impact of a possible US Kyoto commitment on the average household. The estimated cost for the average US household is in the order of an extra $ 3000 to $ 7000 a year, a cut in real living standards that far exceeds any rise in mortgage rates. Estimates of what New Zealanders will have to absorb exceed even what Americans have to expect. In Australia, little has been said about prospective Kyoto costs, but these estimates are taken seriously in the boardrooms where inflationary expectations are shaped.

Maybe, it is time for Malcolm Turnbull and our responsible Prime Minister Kevin Rudd to ask the experts what the NAIRU will be, once Australian workers and consumers are hit by the Kyoto costs on top of the food and energy inflation already in the pipeline.