Working Papers

Yet Another ‘New Era’?

Having promised a ‘new era’ of Reserve Bank independence, the government is now promising the Reserve Bank a ‘new era of fiscal discipline’:

KEVIN Rudd and Wayne Swan have personally told the Reserve Bank of their determination to cut budget spending to reduce the need for further interest rate rises.

Following their meeting at the Reserve Bank’s Sydney headquarters with deputy governor Ric Battellino and Treasury secretary Ken Henry, Mr Swan said they had “flagged a new era of fiscal discipline”.

“It’s critical we demonstrate restraint as we frame our first budget, because that sends a clear message to the Reserve Bank,” Mr Swan said.

For reasons argued here, demand management is the wrong focus for fiscal policy and is not likely to have much impact on interest rates in any event.  Rising interest rates are in fact symptomatic of economic strength, not weakness.  What the government should fear most is that the RBA should start cutting interest rates, since that will be one of the first signs that the Australian economy has succumbed to the deteriorating global growth outlook.  Rising interest rates should be the least of the government’s worries.

This is not to deny that Australia has an inflation problem, but all the finger-pointing between the government and the opposition misses the point that there is only one public institution in Australia with an explicit mandate to control the cyclical component of inflation, and that’s the Reserve Bank.  Next week’s Q4 CPI release will likely show underlying inflation running above the RBA’s 2-3% medium-term target range.  Given the lags between changes in official interest rates and inflation outcomes, this tells us that the RBA was not doing its job properly 12-18 months ago.  The newly elected Labor government has inherited an inflation problem from the Reserve Bank, not the former Coalition government.


posted on 16 January 2008 by skirchner in Economics, Financial Markets, Politics

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You’d have thought the RBA might have had the coglioni to tell them that their impending recollectivisation of labour relations would have a far higher probability of impacting CPI outcomes than fiscal policy, which just goes straight through to the trade balance in an open economy, whereas wages go straight into consumption (and, in turn, into consumer prices).

Then again, if they keep tightening fiscal policy, and it doesn’t do anything about CPI (and it won’t), I suppose the worst they could do is keep cutting spending (boo hoo), however futile it would be wrt CPI outcomes.

Given the lags between changes in official interest rates and inflation outcomes, this tells us that the RBA was not doing its job properly 12-18 months ago.

In your opinion, has the transmission mechanism lag lengthened or shortened over recent years/decades?

Posted by benson  on  01/16  at  03:05 PM

According to the RBA’s macro model, the lag is 1-7 quarters from real cash to the output gap and then 0-3 quarters from the output gap to inflation.  So you should see some impact after one quarter, but the full impact may not be seen for more than two years.  Or as Friedman would say ‘long and variable.’

Posted by skirchner  on  01/16  at  03:47 PM

Re-reading Nigel Lawson’s memoirs, I came upon this passage, which in one respect suggests not much has changed in the last 20 years:

“I had always regarded interest rates as a vitally important *instrument* of policy. But… the Treasury had come to elevate low interest rates into an *objective* of policy. The mandarins were not helped to break out of this mould by the fact that low interest rates had an unfailing appeal to Margaret. Despite her reputation as a diehard opponent of inflation. and her dislike of it was undoubtedly genuine, she was almost always in practice anxious to reduce interest rates… All this powerfully reinforced the traditional Treasury desire to get Government borrowing on a downward path, which it imagined would enable interest rates to move down in parallel. For somewhat different reasons, cutting back Government borrowing was an objective of mine too… Where we differed on the fiscal front was that the official Treasury’s disapproval of public spending… carried over to a distrust of private spending too, and an austere quasi-moral disapproval of any significant reduction in tax rates, even to prevent the tax burden from rising. Saving was always worthier than spending and investment superior to consumption… But I also began in time to realise that the traditional Treasury view greatly exaggerated the extent to which reducing or eliminating the Budget deficit could bring down domestic interest rates. They still had subconsciously in mind a world of exchange control and domestic financial regulation in which the balance of the Budget was a decisive factor in a national capital market, instead of one modest factor in an international capital market where interest rates were largely determined.” “The View From No.11: Memoirs of a Tory Radical” (Corgi Books (1993), p.478)

Maybe Chris Richardson did some time in the UK Treasury?

Posted by .(JavaScript must be enabled to view this email address)  on  01/17  at  09:25 AM

In the 1980s, when most senior UK bureaucrats would have been trained in Oxbridge in the 1950s and 1960s, this kind of thinking was perhaps understandable.  But there is no excuse today.

Posted by skirchner  on  01/17  at  11:05 AM

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