Working Papers

2007 02

What Glenn Stevens Won’t Tell Sharon Grierson About Interest Rates

In comments on an earlier post, the Labor Party’s Sharon Grierson says that:

Our very capable Governor seized on [my] “slip of the memory” but was slightly defensive, even evasive, about the comparative level of our interest rates. Interestingly, so was the PM when the same question was asked of him today in Question Time by Kevin Rudd. The question though remains one that many Australians from all economic interests seek an answer to, and no doubt is one that Australian PMs and Treasurers also reflect upon when considering the movement of inflation rates and the impact of higher interest rates on the wider electorate.

There are several reasons why interest rates in Australia might be higher than in other countries. One reason is that Australia’s rate of potential economic growth is higher than that of other countries with lower interest rates and so our equilibrium real (or ‘neutral’) interest rate is higher.  It is no coincidence that the Australian and NZ economies generally outperform those with lower interest rates.  The real interest rate is ultimately determined by real factors like the rate of return on capital and we want this to be higher, not lower.

Another reason why Australian nominal interest rates might be higher is they incorporate a higher inflation or other risk premia.  To the extent that inflation in Australia is on average higher than in other countries, nominal interest rates should also be higher.  One could lower this inflation premium by adopting a tougher inflation target.  Paradoxically, however, this might require a period of even higher interest rates and reduced economic growth while the RBA established credibility for the new, lower target range.  This would be a much tougher inflation target than the one currently favoured by the RBA and both major political parties.

Most of the short-term movement in official interest rates is due to cyclical rather than structural factors such as those referenced above.  As we have noted previously, you are not going to get ‘low’ interest rates in an environment in which the unemployment rate is making 32-year lows.  The government’s politicisation of interest rates at the last federal election ultimately back-fired, because it put the government on the defensive in relation to interest rates, while diverting attention from the good economic news associated with rising interest rates.

posted on 28 February 2007 by skirchner in Economics, Financial Markets

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The Productivity ‘Puzzle’

The productivity ‘puzzle’ has bothered economic policymakers in Australia for some time now:  employment growth has outstripped what we would normally expect to see based on recent GDP growth, implying declining productivity growth.  As RBA Governor Stevens indicated in his testimony to the House Economics Committee last week, there are dozens of possible interpretations of this ‘puzzle,’ but few that seem entirely plausible or persuasive. 

As the following article from Statistics Canada notes, the productivity ‘puzzle’ is not an unusual phenomenon and one that is shared by countries that have recently experience favourable terms of trade shocks:

Nor is it unusual for Organisation for Economic Co-operation and Development (OECD) countries to experience two (or more) years of little productivity growth. Just since 2000, 10 of the 29 OECD countries for which data are available experienced such an episode. Interestingly, Norway and Australia are both currently experiencing little or no growth in output per employee, and like Canada, both have large natural resource bases, which is the source of much of the productivity slowdown in Canada.

If the productivity ‘puzzle’ is ultimately attributable to the positive terms of trade shock, then it may not be something over which policymakers should lose much sleep.

posted on 26 February 2007 by skirchner in Economics, Financial Markets

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Valuing US Financial Markets

RBA Deputy Governor Ric Battellino made the following observation in testimony before the House Economics Committee yesterday:

The popular perception is that, somehow or other, the US is out there spending a lot of money and has to go around the world borrowing to fund that expenditure. I am not sure that is the correct interpretation of what is happening. I think that what is really happening is that the investors of the world want to invest in the US financial markets. They are inundating the US with money, and the US economy and US households are responding to those financial pressures.

I am not sure that there is a huge problem of US indebtedness. I think this is really a sign that world investors actually very much value the characteristics of the US financial markets. There is no doubt that they have the deepest, most liquid and most credit-worthy financial markets in the world. People who have excess savings want to put a lot of their money in the US.

Regular readers will not be surprised to learn that I agree with this proposition.  What surprises me is that there seems to be so little appreciation of these institutional strengths of the US economy and financial markets within the US itself.  The mistaken notion that ‘global imbalances’ are somehow a problem stems from the failure to recognise this fundamental institutional reality.

posted on 22 February 2007 by skirchner in Economics, Financial Markets

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‘I am not proposing that money be free, but…’

Glenn Stevens’ first appearance before the House Economics Committee in his capacity as Governor of the Reserve Bank saw very little change in the dynamics of these hearings.

Committee Chair and federal member for Qantas, Bruce Baird, did his usual thing of reading out loud newspaper articles and seeking the Governor’s reaction, which says a lot about his level preparation for these hearings.  The Labor Party’s Sharon Grierson disgraced herself with this contribution:

I am not proposing that money be free, but why can’t Australians enjoy the low interest rates being enjoyed by countries like New Zealand.

New Zealand’s official interest rates are of course 100 bp higher than in Australia, but I guess we can take comfort from the fact that she is not, afterall, proposing ‘free money.’

Glenn Stevens avoided addressing the monetary policy outlook directly in his prepared statement, only to make a more explicit statement under questioning (see Terry McCrann on the significance of Stevens’ remarks).  This only serves to highlight the fact that the Bank is being less than candid in its Statements on Monetary Policy and in its opening statements before the Committee.

Governor Stevens’ informed the Committee that his own home was ‘a piece of spec rubbish, built in the 1970s,’ which was somehow meant to be reassuring.  Former Governor Ian Macfarlane also had occasion to note the appalling standard of housing in Australia in his own youth.  Much of the silly prejudice against housing investment among the commentariat in Australia stems from the failure to recognise how woefully undercapitalised Australia’s housing stock has been, at least until the most recent boom in residential investment.

Stevens laid to rest a long-standing myth that there is a convention against the RBA adjusting interest rates in the context of federal election campaigns:

There seems to be a view abroad that there is some almost unspoken tradition that we do not adjust rates in an election year. I have seen a number of references to my predecessor supposedly having said that. I do not recall that he did say that. What I can recall is that he said we would not be all that keen to be changing them in the election campaign. I know that the political process often talks about being in permanent campaign mode, but what I think he meant by that was the formal campaign in the months prior. He also said if it had to be done it would be. So I do not accept, and I do not think we ever could accept, the idea that in an election year—which, after all, is one year out of three—you cannot change interest rates. When you think about that, I do not think any central bank could accept the notion that somehow a rate change is off limits for one year out of three. That would be crazy. So the answer to the question is: if in August it needs to be done it will be done.

Unfortunately, these myths have a life of their own, and this one will almost certainly feature in pre-election commentary this year.

posted on 22 February 2007 by skirchner in Economics, Financial Markets

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‘Carbon Neutral Grannies’: Global Warming Self-Parody Alert

If it were the first of April, I would assume that this was a cruel parody of global warming hysteria.  Unfortunately, it is just self-parody, with front page billing in The Weekend Australian:

All forms of flatulence - from cats, dogs, even from Dad - contain methane, a greenhouse gas thought to contribute to climate change.

If you’ve been feeling guilty about it, help is at hand. For just $8, a Sydney-based company, Easy Being Green, can now make your cat carbon-neutral, so it can “live guilt-free for a year”…

The scheme can be applied to any product, animal or person. For $20, the company made Jenny Cracknell into a “carbon-neutral granny” last year. Her daughter, Emily, gave her a gift certificate to offset two years’ worth of flatulence. “I don’t like to brag, but I actually don’t have much flatulence,” Mrs Cracknell says. “But when I do, I feel OK about it, because the damage to the planet has been offset.”

posted on 17 February 2007 by skirchner in Culture & Society

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Too Busy to be Treasurer

Professor Stephen Bell, author of Money Mandarins, on the delay in filling vacancies on the RBA Board:

I think everyone agrees it took a hell of a long time.  One possible interpretation was the Treasurer was just busy and didn’t get around to it.


posted on 15 February 2007 by skirchner in Economics, Politics

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New Appointments at the RBA

Not before time (see previous post), Treasurer Costello appoints RBA Assistant Governor (Financial Markets) Ric Battellino to the position of Deputy Governor of the RBA. Graham Kraehe AO, Chairman of BlueScope Steel, has also been appointed as a non-executive member of the RBA Board.  For such a conservative choice for the Deputy Governor’s post, the delay in making this appointment is difficult to fathom.  Graham Kraehe’s appointment is unremarkable, although after the Bob Gerard affair, one can only assume he has no outstanding matters before the Tax Office. 

The non-executive board members generally vote in favour of the monetary policy recommendations put forward by the bank’s senior officers.  As I argue here, given the rubber stamp role of the non-executive directors in relation to monetary policy, it would make sense to separate monetary policymaking from the other governance functions of the RBA Board.  As things stand, the main role of the non-executive directors is to allow the Bank’s senior officers to effectively monopolise decision-making.  The non-executive members also provide a convenient, though completely bizarre, argument against releasing the minutes of Board meetings.  The RBA argues that the non-executive board members are too conflicted by their day jobs to have their role in monetary policymaking open to public scrutiny.  In any other governance role, this argument would be completely laughable, but it is one that suits the desire of the Bank’s senior officers to avoid public scrutiny and external interference in monetary policy.

posted on 14 February 2007 by skirchner in Economics, Financial Markets

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The Understrength RBA Board

Treasurer Costello continues to neglect his portfolio responsibilities:

PRESSURE is mounting on Peter Costello to appoint a new deputy governor of the Reserve Bank amid unease in the markets and internally at the length it is taking to beef up the under-strength board…

And with an election due this year, there is a risk that further extended delays could politicise new appointments…

It is now five months since deputy Glenn Stevens succeeded Ian Macfarlane as Governor. But the wait to replace controversial independent member Robert Gerard has blown out to 14 months…

Mr Costello raised eyebrows last year when he said he would look for internal and external candidates to fill the deputy role. But private-sector economists believe any of the three leading internal contenders are more than capable and are puzzled as to why it is taking so long.

A spokesman for Mr Costello said: “The Treasurer has indicated that he will look externally and internally at all the best candidates and that is what is going on.”

Leading contenders for deputy governor are assistant governors Ric Battellino, 55, Malcolm Edey, 47, and Philip Lowe, 45.

There have been rumours Mr Costello could appoint a senior bureaucrat from Treasury to join Treasury Secretary Ken Henry on the board. But recently that rumour mill has slowed. Treasury executive directors Martin Parkinson and Mike Callaghan have been touted as candidates.

posted on 13 February 2007 by skirchner in Economics, Financial Markets

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The RBA’s Inflation Forecast

The RBA’s Statements on Monetary Policy have frequently been criticised on this blog, because up until now they have fallen well short of the detail that has come to be expected from inflation targeting central banks, not least the Bank of England and the RBNZ.  However, the RBA’s February Statement incorporates a significant improvement in the RBA’s presentation of its inflation forecast.

Until now, the RBA has presented its inflation forecast in a very informal way.  For example, the RBA’s November Statement said little more than that ‘underlying inflation will remain at around 3% over the next year.’  By contrast, the February Statement now includes a table with point forecasts for both headline and underlying inflation for the years ended in June and December 2007, as well as an expected range for the years to June and December 2008.  The RBA has also defined what it means by underlying inflation: the average of RBA’s the trimmed mean and weighted median measures of the central tendency of inflation.

This is a significant improvement in transparency on the part of the Bank.  The forecasts for inflation still suffer from not being fully endogenous.  It makes more sense for an inflation targeting central bank to forecast its own policy rate or to incorporate a market forecast for the policy rate and then base the inflation forecast on this projection.  Instead, the RBA still makes its inflation forecast on a ‘no policy change’ basis.  There are arguments for and against endogenising the inflation forecast, but the main argument for is that it makes it more explicit that inflation outcomes are not exogenous under an inflation targeting regime.  But at least now we have a much better insight into how the RBA’s thinking about inflation informs policy outcomes.

Interbank futures are now giving no chance to an RBA tightening in March, although this probability rises to around 36% by August of this year.


posted on 12 February 2007 by skirchner in Economics, Financial Markets

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Index of Economic Freedom Portfolio

First Trust Portfolios LP (who employ Brian Wesbury as their chief economist), has launched a fund that tracks the Heritage Foundation/WSJ Index of Economic Freedom:

This unit investment trust seeks to provide the potential for above-average capital appreciation by investing in exchange-traded funds, closed-end funds and stocks that we believe are representative of the countries that are identified in the 2007 Index of Economic Freedom.

According to the Liberty Investment Group, who have back-tested the portfolio:

Over the past 11 years, the Economic Freedom Portfolio has far outperformed world stocks in general. While the MSCI World Stock Index rose 140% during this time, and the Emerging Markets Index climbed 85%, the Index of Economic Freedom Portfolio rose an astonishing 254%.

posted on 10 February 2007 by skirchner in Economics, Financial Markets

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Downsizing at Doomsday Cult Central

The prolific Felix Salmon gets the boot from Nouriel Roubini’s RGE Monitor.  I always thought Felix was too much of an independent thinker for Doomsday Cult Central.  Felix can now be found at his own site.  In an email, Felix says:

this time round I don’t have people telling me what kind of attitude to take, in terms of either style or substance

posted on 07 February 2007 by skirchner in Economics

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‘Wimps, Ninnies & Pointless Skeptics’: The Anatomy of Davos Man

Michael Lewis gets to the core of what’s wrong with the Word Economic Forum:

Davos is where people with no talent for risk-taking gather to imagine what actual risk-takers might do. Davos Man needs to sit in judgment; Davos Man needs to brood. So great is this need that he will brood about virtually anything, no matter how little he knows about it.

So why do these people waste so much of their breath and, presumably, thought, with their elaborate expressions of concern? Even if these global financial elites knew something useful that you and I don’t — that, say, 50 hedge funds were about to go under and drag with them half the world’s biggest banks along with a third of the Third World — they would be unlikely to do anything about it.

And if they really believe the markets mispriced risk, or were about to adjust, they must also believe they could make vast sums of money if they quit their day jobs and opened a hedge fund to take the other side of stupid trades. But they don’t really believe that, or at least some of them would be off doing it, rather than spilling the beans to Bloomberg News.

Is perhaps the only point of standing in the snow and expressing your doubts to a television camera to prove that you are the sort of person whose doubts matter?

Speaking of economic girlie men, Nouriel Roubini is now trying to put me out of business, by providing his own self-critique:

Readers of this blog may also think that the second paragraph above is a [sic] typical Roubini “doom & gloom” fear mongering and describing a scenario that is totally unlikely to occur in 2007.

Just what Nouriel said!

posted on 02 February 2007 by skirchner in Economics, Financial Markets

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I Know What Nouriel Roubini Did Last Summer III

Nouriel Roubini’s forecast of flat US GDP growth in Q4 lies in ruins.  Reaction from Brian Wesbury:

Real GDP increased at an annual rate of 3.5% in Q4, beating the consensus forecast of 3.0%.  Real GDP was up 3.4% versus a year ago…

Today’s GDP report shows that the economy remained strong in Q4 and suggests robust growth ahead.  There are still no signs that the on-going correction in the housing market is damaging the rest of the economy.  Excluding housing, real GDP growth would have been 4.8%. Consumption and business investment, combined, contributed 3 percentage points to the real GDP growth rate.  Although business investment declined for the first time in almost four years, we believe this will be reversed quickly as firms make use of the past few years of high profit growth and strong corporate balance sheets.  Moreover, the decline in inventory investment in Q4 makes room for more GDP growth in early 2007.  We also note that the growth rate of nominal GDP over the past two years shows the Fed is still loose and higher inflation is in the pipeline.  Nothing in today’s data alters our 2007 outlook for both better growth and more inflation than the consensus expects.

And from Action Economics:

Whereas some analysts in 2006 focused on whether the growth slowdown was excessive, the real issue is whether it will prove adequate to relieve pressure on inflation, as was our concern, and the stated concern of the FOMC since the start of the policy “pause.”

Nouriel now ludicrously refers to his ‘current view of a 2007 hard landing with a growth recession.’  As with all his previous forecasts of gloom and doom, Nouriel’s recession call is forever receding into the distance. 

UPDATE: Reaction from the WSJ:

you may have noticed that 2006 ended without a recession. This follows the recessions of 2003, 2004 and 2005, all of which also never occurred, though they were widely warned about in the press and even forecast by many economists at some point during each of those years.

posted on 01 February 2007 by skirchner in Economics, Financial Markets

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