Since the mid-1990s the Reserve Bank of Australia has been independent from government, and recently it has been highlighting that independence. Numerous statements and speeches by the executive of the RBA have noted how monetary and fiscal policy are now working against each other. Monetary policy has been working as expected, fighting against a headwind of government cuts to spending.
It looks clear the RBA would like this to change. With interest rates at record lows, many economists and even the governor of the RBA, Glenn Stevens, have noted the diminishing returns of monetary policy. In essence the worry is that, while cutting interest rates from 7% to 5% might encourage people and businesses to invest, there are fewer people or businesses who would not invest at 3% but would if the cash rate was cut to 2%.
In February Glenn Stevens told the House economics committee that the RBA was concerned that “monetary policy’s power simply to summon up more demand with lower interest rates could be less than it used to be.”
He did not, however, think monetary policy was useless. He suggested the bank did not believe “that monetary policy has reached the stage where it has no ability at all to give additional support to demand in the economy”. The RBA still felt it “has some ability to do that and to assist the transition the economy is making, and we regarded it as appropriate to provide that support”.
It now appears the recent ability of monetary policy to stimulate the economy has been as strong as ever.
This week a speech by the RBA’s assistant governor, Christopher Kent, revealed that according to the bank’s analysis, monetary policy is working about as effectively as it did in the past.
He noted the historical assumption is that cutting the cash rate by 100 basis points (i.e. 1 percentage point) will lead GDP to be higher than otherwise by about 0.5% to 0.75% over the course of two years. Such a cut would also cause inflation to rise by “somewhat less than 0.25 percentage points per annum over 2–3 years”.
From November 2011 to May 2013, the RBA cut the cash rate by 200 basis points, from 4.75% to 2.75%. Since then it has cut it another 75 basis points to its current rate of 2.0%.
The RBA’s research, according to Kent, suggests that “the overall effect of monetary policy has not changed significantly in recent years”.
That we are currently experiencing such low growth does not, in Kent’s view, mean monetary policy is not working as well as it should, but that there have been a number of large “exogenous forces or shocks” – that is, negative impacts outside the control of monetary policy.
Kent noted these negative shocks included “the sharp fall in commodity prices” and also “weakness in private investment – beyond that which can be explained by subdued domestic demand and falling commodity prices”.
Among the areas Kent pointed to which demonstrated the ongoing effectiveness of monetary policy was housing construction.
The mass of discussion about a house price boom in Sydney clearly has shown that cutting rates has had an impact. But the RBA is more concerned about the impact on housing construction. If all low interest rates are doing is raising housing prices, then it is doing little good. But the growth in construction since the RBA began cutting rates in November 2011 shows there has been a clear impact:
So, while there have been shocks to the economy, monetary policy has had an impact, but the RBA has been quite vocal of late to let it be known that it feels like it is doing all the work.
When announcing the interest rate decision in the first week of June, the governor’s statement noted, after highlighting the weak levels of private demand, “public spending is also scheduled to be subdued”.
The minutes of the June monetary policy meeting also noted that the bank was not just looking at the federal government but also the “the fiscal positions of the states and territories” when it came to assessing “the effect of fiscal consolidation on the aggregate economy”.
And then last week, Glenn Stevens told the Economics Society of Australia that economic growth was weaker than the RBA had previously hoped it would be. He suggested that “the most recent indications are for, if anything, a weakening over the year ahead”.
He followed this statement by immediately noting that “public final spending has not been growing and fiscal consolidation still has some way to run”.
On this he provided some rather pointed advice to federal and state governments, arguing that given the current weak growth in the economy, “it would seem inappropriate for governments to seek additional restraint here in the near term”.
One of the reasons we have low interest rates is because governments have not been spending in a manner which would provide greater stimulus to the economy. The latest growth figures on government consumption shows just how low it is currently:
Now, to an extent that’s fine. Indeed it’s a choice. During the global financial crisis, Joe Hockey argued government spending should have been lower so as to have allowed interest rates to be lower. Now he argues that the government is creating room for the RBA to cut rates.
But the bank is increasingly seeing the government working against what the RBA is trying to do.
In his speech, Christopher Kent listed “fiscal consolidation at state and federal levels” along with “the significant decline in mining investment” as one of the “headwinds” against which monetary policy is working.
He also noted that while monetary policy is working well in spite of these headwinds, one issue was that “consumption growth has been a bit weaker than in the past”.
Certainly, when we look away from housing, the spending patterns don’t look to have reacted as strongly. The latest motor vehicles sales figures show the growth of sales of new cars seems to have peaked – and peaked at a very low annual growth of 2.3%:
Thus demand in the economy remains weak, and non-housing spending is sluggish.
For most of the past three years the desire to restrain government spending had meant that most of the work to keep the economy ticking along has been up to the Reserve Bank.
The RBA believes monetary policy has thus far been working as expected. But the record low interest rates that have resulted from the RBA stimulating the economy have also brought with them the risks that occur when there is an abundance of cheap money – worries about a housing bubble and risky investment lending.
The need to keep the exchange rate low (one of the other headwinds Kent spoke of) means the RBA will remain open to cutting rates further. However, when the RBA governor is warning governments against any more fiscal “restraint”, it’s clear the bank is feeling a bit like Lebron James in the NBA finals – the one doing all the work.
It’s also clear that without more of a hand from governments – via fiscal stimulus – it believes the current period of low growth will continue.
