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 MARKET REPORTS |
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Economic commentary
Wolf, wolf!
November 7, 2007
Dr Ron Woods, Econoclast
Today marks the 17th anniversary of Australia embarking upon a policy of targeting inflation as a
first priority. Sadly it also is the day the RBA raised official cash rates for the 10th time since the
last rate cut in December 2001.
It is sad because I believe the RBA has lost sight of what they are targeting and in the process risk undoing society’s commitment to that very policy. They risk doing this by unnecessarily raising cash interest rates too far. That will attract criticism and undermine the public’s commitment to the policy. That may lead to a reversion to the bad days of the 1980s where inflation was a low priority in economic management and we suffered as a result.
One of the architects of inflation targeting, then RBA Governor Bernie Fraser warned against the type of dogmatic approach to monetary policy now being used. In a speech three weeks after the start of inflation targeting in 1990 Mr Fraser said the commitment must be backed “by firm, credible but non- doctrinaire actions.
Credibility is critical in determining the costs of reducing price
expectations: the public need to be convinced that inflation can be lowered without putting the
economy on the rack. Credibility, it has been said, is ‘difficult to acquire, easy to lose and never to be taken for granted’”. This tenth rate hike could undermine that credibility.
The first five rate hikes in this series of ten (so far) were trying to stop house price inflation. The
hikes started in May 2002, long after the housing bubble was ballooning out of control and causing
a massive inflationary distortion of the economy the after effects we still suffer today; effects such
as the “housing affordability crisis” and “John Howard’s reelection crisis” among others.
The last
five rate hikes since May 2006 have occurred after the publication of the preceding CPI has shown
by the RBA’s own internal calculation a large quarterly rise. The RBA adhere to an obsolete
economic theory (the Phillips Curve) that says when the unemployment rate falls, “inflation” rises.
The last five rate rises have become an automatic response to lagged data in the very doctrinaire
fashion that Bernie Fraser warned against 17 years ago. This is especially the case because to say
we currently have an inflation problem is a myth. Even if you believed in that myth, the Phillips
curve itself is false as the chart shows and this has both “underlying” and headline CPI plotted
against the unemployment rate.
As the truth is being ignored the resulting rate hikes will likely
push cash rates too high, restrict the domestic economy and put at risk its sustainability and in the
longer term undermine society’s commitment to fighting inflation first. That could lead to the
policy being abandoned.
When the time comes that we really have an inflation problem the central
bank may not be able to do much about it other than cry wolf.
Dr Ron Woods, regarded as one of Australia's leading market economists, has a knack for being far ahead of the curve in assessing the direction of the economy. With a PhD in Economics, Dr Ron Woods is a well-known commentator on economics and interest rates, and has worked for the Commonwealth Bank, Bankers Trust, NM Rothschild and Challenger. Dr Ron Woods produces the newsletter Econoclast, a fresh look at Australian economic events.
More articles from the latest edition of CompareShares:
Economics: Wolf, wolf!
Rates outlook: RBA to raise rates to 7.0% at one of the next two meetings
Rates: RBA ups interest rates to 11-year high
Rate rise impact: Households 'should rethink budgets'
Trading: Buy the rumour, sell the fact
Investing: Why investors shouldn’t trust their own judgement
Forex: Hitchhiking on the carry trade
Commodities: Global commodities bull flexes its muscles
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