There’s lots of talk about Philip Lowe’s tenure at the Reserve Bank (RBA). As we read in The Monthly — those of us with strong stomachs, that is — Jim Chalmers wants to “renovate” the RBA. Normally renovation doesn’t include decapitating and replacing the head of the household. But who knows what’s in jejune Jim’s leftist mind. Lowe must be nervous, come September, of being denied another seven years at the helm. On the other hand, for all I know he has more exciting things in prospect and will resign before they get a chance to sack him.
Enough of this idle talk. First, an excuse for Lowe.
He did very little wrong that other central bankers didn’t do. He was just too plucky in airing his ponderings that rates would remain close to zero until 2024. It would have served him better, as Yogi Berra and others reputedly said, to never to predict (especially aloud) about the future.
That aside, it’s best to remember that central bankers are not free spirits. They tend to move as a pack to avoid being the maverick, which isn’t a good look in central bank circles. They all brought down interest rates too low and allowed inflation to gather speed. Then, once it gathered speed, their Keynesian economics, which led to the problem in the first place and which they all share, have given them no clear guidelines as to when enough is enough of interest rate increases. They are misled on the way down and on the way up.
One result is that you get this very silly business of watching the latest inflation figures to guide policy. The media don’t help. Economics 101; to wit, says lags mean that the effect of policy is seen down the track. Current observations are usually misleading.
The other plague on good policymaking is to look at the relationship between interest rates (official cash rate now 3.35 per cent) and inflation (December quarter 7.8 per cent) and conclude that the real interest rate (3.5 minus 7.8) is negative, and thus do rates need to rise much further. I note that some pretend economists fall into this trap for simpletons. The current inflation is an irrelevant variable. Inflationary expectations are what count. And it seems likely that the current expectation is for inflation to fall. Equally, the interest rate to be considered is not the cash rate but the rate at which money can be borrowed by households and businesses and, moreover, set against the anticipated return on the money borrowed. Business is much more likely to be gung-ho when borrowing at, say, 7 percent when 17 percent is to be made, than if only 10 percent is to be made. It’s very complicated, can’t be calculated, and we shouldn’t bother with it.
Instead of focusing on interest rates, central banks should go back to Milton Friedman and focus on the growth of money aggregates. (I covered this more fully last year.) It’s not hard, which is perhaps why economists shy away from it. After all, if your next-door neighbour can understand it, what was the use of all that studying? Inflation is a persistent increase in the prices of goods and services taken as a whole. Equivalently, it is a persistent reduction in the value of money. What leads to such a persistent reduction in the value of money? “Printing” too much of it.
Printing connotes wheelbarrows of (paper), assignats in revolutionary France and Papiermarks in the Weimar Republic. These days most money consists of bank deposits, and the creation of most money is through bank lending. Nevertheless, too much of it causes inflation and the root cause, as ever, is governments spending more than they raise in taxes and borrowings. In turn, this increases deposits held by banks in central banks which provide the wherewithal for banks to lend.
What is the RBA (and other central banks) to do? Persuade the government to be less spendthrift? Forget that one, particularly if a Labor government is in power.
What the RBA must do is to adjust interest rates to keep the growth in monetary aggregates under control. The focus should not be on the level of interest rates. That’s the instrument. The focus should be on the growth of money; that’s the target. Sure there are three or four different definitions of money. But an average of them all would do, save picking one – which would also probably do.
In the two years between December 2019 and December 2021, according to RBA figures, M1 money (cash plus bank current a/c deposits) increased by over 50 per cent. M3 money (M1 plus other deposits in banks and in other authorised deposit-taking institutions) increased by over 23 percent. During the same two-year period the economy (real GDP) grew by just 5 percent. Bit of gap there. And it’s no surprise, except apparently to central bankers, that it will eventually find its way into rising prices.
What have monetary aggregates done in 2022. Well M1 peaked in May 2022 and has been trending down since. M3 is still going up but at a much reduced rate. Bank lending provides an early indication of what’s happening and the RBA should have intelligence on the very latest figures.
The question is whether the RBA is focusing on the right variables – bank lending/monetary aggregates – or whether it remains besotted by the latest CPI figure. If it’s the latter it is bound to get it wrong in raising interest rates too much, as it got it wrong in reducing them too much.