Here's why Australia's 1.5% interest rates are too high

Tue, 05 Feb 2019  |  

This article first appeared on the Yahoo Finance web site at this link: https://au.finance.yahoo.com/news/heres-australias-1-5-interest-rates-high-002038269.html 

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Here's why Australia's 1.5% interest rates are too high

Australians love talking about interest rates and the bulk of economic commentary day-to-day is about whether or not the Reserve Bank of Australia will be putting them up, or down or leaving them steady at their next monthly meeting. This is no doubt linked to the huge interest of most Australians in house prices and the fact that household debt levels are amongst the highest in the world.

A small change in interest rates can have a significant impact on those with large mortgages.

Are interest rates too high or too low?

Having watching the RBA over the last 30 years or so, I have learnt a few lessons when it comes to working out whether interest rates are too high, too low or just right.

These lessons boil down to the following observable and easily tested facts on the economy.

If the economy is registering a decent rate of economic growth, say around 3 per cent, there are sufficient jobs are being created to keep annual wages growing by about 3.5 per cent and most importantly, annual inflation is hovering around 2.5 per cent and looks like staying at that rate, the prevailing interest rate is about right.

It seems simple when it is laid out that way.

Right now, economic growth is slowing to below 3 per cent and based on the data on housing, consumer finances and the global economy, it is probably on a path to about 2 per cent by the second half of 2019. Adjusting for population growth, the economy is getting uncomfortably close to a recession.

At the same time, wages growth is struggling to pick up from record lows and is stuck at a weak 2.25 to 2.5 per cent. This is too low and wages growth is being held back by the simple fact that there aren’t enough jobs being created to get unemployment and underemployment sufficiently low to spark a pick-up in wages.

Then there is inflation. The December quarter results released last week showed annual underlying inflation at 1.8 per cent. This confirmed that annual inflation has been below the bottom of the RBA target range of 2-3 per cent for 3 consecutive years and it has been below the mid-point of the target for 5 years.

This is the clearest indicator of all that interest rates in Australia are restrictive, or too high in other words.

Mortgage holders should shop around

It might seem odd to conclude this when the official interest rate is 1.5 per cent and most mortgage holders can shop around and get an interest rate around 4 per cent. But such is the change in the domestic and global economy in the aftermath of the global financial crisis. Inflation and therefore interest rates around the world are low.

Of all industrialised countries, the US has the highest interest rates at 2.5 per cent and there is a real possibility it will be cutting those rates at the end of 2019. Interest rates in Europe and Japan are negative. They are 0.75 per cent in the UK and in Canada, rates are 1.75 cent.

In an ideal climate for Australia, GDP growth should be higher, wages growth stronger and inflation should be above current levels.

It’s not rocket science to work out a formula to work out how policy makers in Australia could achieve that – lower interest rates are the answer.

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“Bitterly disappointing”: We are seeing a once in a generation policy failure

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It would be immensely satisfying to change policies to improve the living standards and quality of life for every day, hard-working Australians and their families.

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Doing nothing, unwilling to pump some much needed cash into the economy because of a political dogma wedded to a notion that budget surpluses are good and that holding interest rates unnecessarily high so you might dampen demand for houses – which is seen as a problem - and household debt overwhelms your power to make things better.

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The RBA admits it stuffed things up – sort of

The Reserve Bank of Australia needs to be congratulated for publishing research which implicitly confirms that it made a mistake when setting monetary policy in the period mid-2017 to early 2019.

Not that the research explicitly says that, but the RBA Discussion Paper, Cost-benefit Analysis of Leaning Against the Wind, written by Trent Saunders and Peter Tulip, makes the powerful conclusion that by keeping monetary policy tighter in order to “lean against” the risk of a financial crisis, there was a cost to the economy that is three to eight times larger than the benefit of minimising the risk of such a crisis eventuating.

The costs to the economy includes lower GDP growth and higher unemployment, that lasts for at least for several years.

A few terms first.

According to the Saunders/Tulip research, “leaning against the wind”, a term widely used in central banking, is “the policy of setting interest rates higher than a narrow interpretation of a central bank’s macroeconomic objectives would warrant due to concerns about financial instability”. In the RBA’s case, the “narrow interpretation” of the RBA’s objectives are the 2 to 3 per cent inflation target and full employment.

In the context of the period since 2017 and despite the RBA consistently undershooting its inflation target and with labour underutilisation significantly above the level consistent with full employment, the RBA steadfastly refused to ease monetary policy (cut official interest rates) because it considered higher interest rate settings were appropriate to “lean against” house price growth and elevated levels of household debt.