Interest rate myths

With last week’s cut, Australia’s cash rate has fallen to its lowest level in decades, possibly longer. Along with the usual roulette as to whether the banks will pass the full benefit on to customers, there is a growing chorus of voices criticising the decision; saying that monetary policy is now powerless, or that the RBA should hold its firepower in reserve for a real crisis.

While there are certainly real concerns over the level of interest rates, and the conduct of monetary and fiscal policy, it’s important to understand what the rate cut means — and what it doesn’t mean.

First, we need to dispense with the myth that low interest rates mean loose monetary policy (denoting the encouragement of an increase in inflation and nominal economic growth).

On the contrary, the way you determine whether monetary policy is accommodating or not is to look at the level of inflation and growth.

And right now, both figures are well below where they should be. Inflation, in particular, has been at or below the bottom of RBA’s target level (2% to 3%) for a number of years.

This is important because it is one reason why the argument that the RBA is powerless is incorrect. A more likely explanation is not that the RBA has been too accommodating (and has been ineffective), but that the RBA has been too timid.

After all, inflation has been at or below target for the last three years, yet interest rates remained unchanged. However, won’t that mean we hit 0% interest rates? Yes — and that is neither a disaster nor the end of the RBA’s tool chest.

This is the other problem with the idea that monetary policy is impotent: it relies on the assumption that tweaking the interest rate and hoping for the best is all the RBA can do. Implicitly it assumes, the RBA cannot generate inflation regardless of how hard they try.

No-one is suggesting that hyperinflation is a good idea, only that if the RBA wanted to boost inflation they could. That means that low inflation is — implicitly or explicitly — a choice.

In many ways, this is an understandable mistake: for most of the 20th century, the problem was far too much inflation, not too little. Central bankers remain hesitant to unleash the inflation genie, for fear they could not get it back under control.

We don’t want a repeat of the stagflation of the 1970s, but nor do we want to follow Japan into decades of dead deflation. Low interest rates, low inflation and low growth, is not a good place to be.

The RBA needs to do its bit to keep nominal growth high. The government needs to step up, as well.

However, this does not mean (as some would like to think) the government should run big, stimulatory deficits. The inaction by the government has not been deficit spending — of which there has been plenty — but the complete absence of microeconomic reforms that would generate real economic growth.

If we want economic growth, we need to encourage business investment. We need to generate more competition, and we need to unlock the power of the market.

This is the real limit of monetary policy: its influence is primarily on the nominal economy and will only keep slow economic growth at bay in the short term. It is not a replacement for good government.

This is an edited extract of an opinion piece published in the Canberra Times.