WITH unemployment still running close to 10 per cent and underlying inlfation at about two per cent, many are astonished at suggestions that "the authorities" should soon start to lift short-term interest rates. One recent proposal is even for a "quick pre-emptive strike", involving a one to two per cent increase, to signal that they are serious about controlling inflation.
Many are even more amazed that long bond rates (which unlike short rates are determined by "the market") have already risen so sharply -- and by more than in overseas counrties. At nearly 10 per cent, long bond rates now stand more than 2.25 per cent higher than they were a year ago (and about 3.5 per cent higher than the pre-Budget low in February), while the official short-term rate for "cash" (4.75 per cent) is still about 0.5 per cent lower than a year ago.
There are two main reasons why the "real" bond rate is now at an historically high level of seven to eight per cent.
First, the authorities do not have a good track record in keeping inflation under control: indeed Australia has a worse record than most OECD countries. Moreover, unlike New Zealand, there have been no changes in institutional arrangements to depoliticise the operation of monetary policy and the Prime Minister's rejection of any need to tighten monetary policy has reinforced his boast that he has the Reserve Bank in his pocket. Little wonder that our long-term bond rate is now more than two per cent higher than New Zealand's.
Of course, the Prime Minister and the Reserve Bank governor keep on declaring that the bond market has got it wrong. They assert that there are no indications of any revival of inflation and that the market should accept their statements that inflation will be kept below three per cent per annum and that the one per cent Budget deficit target will be achieved.
Politically, it is scarcely surprising that the authorities are not accepting any early timetable for monetary policy tightening. That would be an admission that the Budget strategy was wrong. The Government's theory is that, even with the strong growth forecast in domestic spending, there is sufficient excess capacity to avoid inflationary pressures for a considerable period.
Indeed, Treasury secretary Ted Evans recently asserted that we could continue growing quite rapidly for some years without such pressures arising. However, Mr Evans also revealed that, without the further supply side reforms this statement was based upon, Treasury modelling suggests that the long-term growth potential of the economy would be only 2.25 per cent per annum once the slack in the economy is taken up.
This implies that, without measures to quickly lift the underlying historical productivity growth of around 1.25 per cent per annum, capacity constraints could emerge within a year or so. Given the time lag of 12 months or more before a tightening in monetary policy takes effect, this suggests the need for early action.
This leads to the second reason for high bond rates, which is the widespread concern both here and overseas that governments will continue as large net borrowers even as businesses are also now increasing their call on savings. Notwithstanding projected reductions in existing large structural budget deficits, is little confidence that governments will fulfil promises to wind back their borrowings sufficiently to make room for expanded private-sector demands.
This raises the prospect that the growing calls on a world of low savings will clash and force interest rates up right across the spectrum.
Markets do not always get it right and it may be that the surge in bond yields will prove excessive: it certainly would be if governments (particularly the United States Government) responded by tightening policies. As there is no pressing external constraint here at present the authorities can sit it out for the immediate future and avoid lifting short-term rates.
The costs in doing so are that higher longer-term interest rates than are necessary inhibit business investment and that delay reinforces doubts about the inflation objectives of monetary policy. Also, once the Federal Reserve moves from its present (almost) neutral stance into a serious tightening mode, markets may re-assess the outlook for further commodity price rises and the Australian dollar could then come under pressure. But a tightening by the Fed could then be the trigger for one here.
Whenever the first tightening comes the same question will arise as in the '80s -- if the public sector had reduced its call on resources faster and by more, wouldn't there have been greater scope for the private sector -- and the external part of that sector in particular -- to expand without having to tighten monetary policy? In the '80s, the Government did eventually move to a Budget surplus, which it is not proposing to do now. (It is ironical that Victorian Labor promises a current account surplus while its federal counterpart will likely have a current account deficit even when the economy is operating at full capacity!). But that was not nearly enough to accommodate the growth in the private sector, with the result that we ended with the recession we didn't have to have.
There is surely a lesson here that this time the Government needs to do more -- and sooner -- on both monetary and fiscal policy. In the '80s, Mr Keating produced several mini-budgets and he could do a lot worse than foreshadow one now for August.
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