The Macro Policy Division of Labour
The Treasury’s David Gruen reminds Senators who is responsible for demand management and inflation control:
Dr Gruen said the RBA strategy of raising interest rates was the most effective method of bringing inflation under control, but budget cuts proposed by the Rudd Government would help.
“Monetary policy responds quickly, and for that reason is our primary tool around demand management,” he said.
posted on 21 February 2008 by skirchner in Economics, Financial Markets
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What is the NAIRU for Australia?
Opposition Treasury spokesman Malcolm Turnbull sought to put Treasurer Swan on the spot yesterday, asking him to nominate Australia’s non-accelerating inflation rate of unemployment (NAIRU). The question was specifically designed not to get an answer. I dare say Malcolm can’t answer this question either. If he can, he has chosen the wrong profession.
The NAIRU is one of those latent variables that is inherently unobservable and likely changes over time. The concept is thus not very useful in the real-time conduct of macroeconomic policy. The more important focus for policymakers is to ease the NAIRU constraint on growth, by lowering the structural or non-cyclical component of unemployment.
By way of comparison, New Zealand also currently enjoys a record low unemployment rate of 3.4% compared to Australia’s 4.1%. Recent inflation outcomes suggest that both economies are likely facing the NAIRU constraint. Yet on some measures (eg, non-tradeables inflation) Australia’s inflation performance is currently worse than that of New Zealand, despite its higher unemployment rate. We can reasonably infer that New Zealand’s NAIRU is somewhat below that of Australia. The 0.7 percentage point differential in the unemployment rate between the two countries reflects the additional structural unemployment Australian policymakers have been willing to accept in their choice of labour market institutions compared to those favoured in New Zealand.
posted on 19 February 2008 by skirchner in Economics, Financial Markets, Politics
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What Does RBA Tightening Do to the Economy?
David Uren writes:
WHAT does a 0.25 per cent rate rise do to the economy?...
The Reserve Bank, like other central banks around the world, keeps its own estimate of the effect of its actions a secret.
In fact, the RBA’s published research on this question is reasonably explicit. The latest iteration of the RBA’s policy simulation model estimates the long-run elasticity of the output gap with respect to a sustained increase in the real cash rate of 100 basis points at 1.0 (ie, real output 1% below potential output), with most of the impact seen within three years. Significantly, the real cash rate enters the model as a deviation from an assumed neutral real cash rate of 3%. As we have noted previously, the real cash rate has only recently moved significantly above neutral based on headline inflation. To that extent, it is only recently that monetary policy has been exercising any restraint at all on the economy. Much of the tightening in the nominal cash rate in recent years has simply been offset by rising inflation.
posted on 18 February 2008 by skirchner in Economics, Financial Markets
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Business Spectator Column
Readers may have noticed that I have an occasional weekend column over at The Business Spectator.
If you would like to receive an unedited version by email on Fridays, let me know and I will put you on the distribution list. Email info at institutional-economics dot com.
posted on 16 February 2008 by skirchner in Economics, Financial Markets
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None Dare Call it Conspiracy II
Terry McCrann remains hard on the case of the AFR’s resident conspiracy theorists:
Now Harris’s substantive assertion was that Treasury had unexpectedly cut the inflation forecasts from the previous year’s 2.9 per cent.
That was wrong. He did not tell readers that Treasury had actually increased its CPI inflation forecasts. From 2.5 per cent in both years in the May budget to 2.75 per cent for both years in the MYEFO/PEFO.
Crucially, those are for year average - all of 2007-08 over 2006-07 and the same for 2008-09. They were exactly consistent with the-then latest inflation forecasts from the Reserve Bank.
It should hardly be surprising that the Treasury and the Reserve Bank are mostly in agreement on the inflation outlook. Since the Treasury Secretary is an ex-officio member of the Reserve Bank Board, he notionally presides over both sets of inflation forecasts. A Treasury forecast that deviated too far from the RBA’s forecast might be seen as an implicit criticism of the Reserve Bank and its Board. If Treasury were to forecast inflation outside the target range, it would effectively be accusing the RBA of presiding over a monetary policy error, one in which the Treasury Secretary was necessarily implicated. It should also be pointed out that the Treasury and RBA forecasts are not strictly comparable, if only because the forecasts are made at different points in time. If a week is a long time in politics, it is also a long time in the forecasting business.
According to Governor Stevens, the Board operates under a doctrine of collective responsibility. If there were any substance to this doctrine, then a Board member who takes a different view on inflation to the one publicly endorsed by the Bank needs to either reconcile himself to the Board’s majority view, or resign. Since the Treasury Secretary is a member of the Board by statute, the latter is not exactly an option.
Rather than looking for non existent conspiracies, the AFR might instead go in search of the rather more obvious conflict of interest. The Treasury Secretary should not be a member of the RBA Board.
posted on 16 February 2008 by skirchner in Economics, Financial Markets, Politics
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Zero ‘Bubble’
Some refreshing ‘bubble’ skepticism from Alex Tabarrok:
So if the massive run-up in house prices since 1997 was a bubble and if the bubble has now been popped we should see a massive drop in prices.
But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average (see chart in the extension).
In the shift to the new equilibrium there was some mild overshooting, especially due to the subprime over expansion, but fundamentally there was no housing bubble.
posted on 14 February 2008 by skirchner in Economics, Financial Markets
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Which is Tighter, Monetary or Fiscal Policy?
Every time RBA Governor Glenn Stevens opens the newspaper these days, he must give thanks for having such a tame press. On his own forecasts, both headline and underlying inflation in Australia will have a three in front of it for the rest of this decade and the first half of 2010. Yet with the honourable exceptions of Terry McCrann and Alan Wood, Australia’s economic commentators are near unanimous in arguing that it’s all the fault of fiscal policy (meaning tax cuts).
This view misunderstands Australia’s macro policy framework, which assigns the job of demand management and inflation control to the Reserve Bank. Those who are opposed to further tax cuts are effectively arguing that the government should engineer a taxpayer-funded bail-out of monetary policy. Needless to say, this strategy won’t work, because higher taxes would simply add to supply-side constraints in the labour market.
It also ignores the obvious conclusion to be drawn from two very simple metrics that can be applied to assess the stance of monetary and fiscal policy. The Commonwealth’s 2005-06 and 2006-07 underlying cash surpluses were at their highest as a share of GDP in nearly 20 years. Fiscal policy is thus unambiguously tight, even after all the previous tax cuts that the commentariat have for the most part opposed.
The same cannot be said for the real official cash rate, the best measure of the stance of monetary policy. With underlying inflation at 3.6% in Q4, the ex-post real cash rate was a mere 3.15% taking the year-ended official cash rate of 6.75% and 3.4% using the current official cash rate of 7.00%. According to the RBA’s own policy simulation model, Australia’s neutral real cash rate is 3%. So when the RBA’s Statement on Monetary Policy says that monetary policy is ‘on the restrictive side of neutral,’ it is talking about less than 50 basis points. With the RBA’s own inflation forecasts having a three in front for as far as the eye can see, the ex-ante real interest rate is at best 4% (assuming steady policy).
As the following chart shows, the ex-post real cash rate only moved to the restrictive side of neutral at the beginning of last year. Monetary policy has been too easy for too long. Hence the inflation problem.
posted on 13 February 2008 by skirchner in Economics, Financial Markets, Politics
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No Malcolm, Wayne Swan is Not Making this Up
One of the referees for an article I have forthcoming on Australian monetary policy queried my assertion that Australia’s inflation target is poorly defined, although subsequently came around to my view that the Statement on the Conduct of Monetary Policy makes this less than clear. The Statement refers to ‘consumer price inflation,’ but is otherwise silent on which of many possible measures of consumer price inflation could be used in determining whether the inflation target has been met.
The confusion this causes was nicely illustrated by Shadow Treasurer Malcolm Turnbull in an interview over the weekend, in which he accused Treasurer Swan of making up the inflation figures:
BARRIE CASSIDY: But what was it in the December quarter though, what was the figure in the December quarter? The one that this Government inherited? 3.6 per cent. A 16-year high.
MALCOLM TURNBULL: No it wasn’t. Ok, now that is a complete untruth. Now Wayne Swan keeps on saying that. I challenge you, invite all of your viewers to go to the Reserve Bank website. You’ll see there that the headline CPI (consumer price index) which is the one that is the inflation targeting is benchmarked against as recently - emphasised again - as recently as December 6 by Wayne Swan himself. That was 3 per cent. In fact, it was 2.96 per cent. The other measurers of inflation, so-called “underlying inflations”, which are statistical adjustments are ... none of them were 3.6 per cent, not one. So, where the 3.6 per cent comes from, I could make a guess but it is not one that was published by the RBA.
The 3.6% figure is an average of the two statistical measures of underlying inflation, the weighted median and the trimmed mean, now published by the ABS rather than the RBA. The RBA references this average in the underlying inflation forecasts contained in the quarterly Statements on Monetary Policy. But unless you are an avid reader of the footnotes to these Statements, you could be forgiven for missing it. The RBA uses this measure because it captures the persistent component of inflation that is of most concern for policy purposes.
Turnbull’s comments reflect a larger problem, which is that this definition of underlying inflation has never been properly announced by the RBA or explicitly endorsed by the current government. Those of us in financial markets first discovered the RBA was using it only by a process of educated guesswork. The May 2006 increase in interest rates caught financial markets by surprise, because markets were then accustomed to looking at a different measure of underlying inflation. It was only when the RBA characterised ‘underlying consumer price inflation’ as being ‘around 2¾ per cent’ in the statement accompanying the May 2006 increase in interest rates that it became apparent what measure the RBA was using, but even this inference was only possible by a process of elimination.
An inflation targeting regime works largely by conditioning inflation expectations. But if even the Shadow Treasurer doesn’t know or doesn’t accept the RBA’s working definition of underlying inflation, we should not be surprised that we have an inflation problem.
posted on 11 February 2008 by skirchner in Economics, Financial Markets, Politics
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Tax Cuts Cause Recessions!
If you think tax cuts lead to higher interest rates, then I guess it follows that you would also believe that tax cuts cause recessions. From someone who should know better:
This is no joke: Kevin Rudd’s tax cuts will increase the risk of a recession in the second year of his first term.
posted on 09 February 2008 by skirchner in Economics, Financial Markets
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None Dare Call it Conspiracy
Terry McCrann on the AFR’s conspiracy theorists:
Despite the “best” efforts of The Australian Financial Review during the week to concoct an absurd conspiracy out of the Treasurer and Prime Minister’s “shock discovery” of an inflation problem.
Did anyone down at the Fin notice that the Reserve Bank increased the official interest rate smack in the middle of the election campaign? Something that it had never previously done, and was regarded by many as something it would never - or even should - do?
That sorta, kinda, suggested someone in the official family was worried about inflation. Worried enough that it couldn’t wait a couple of weeks until the election was out of the way.
The very strong suggestion from some quarters that that was exactly what the RBA should do, so as not to “politicise” rates, provides an interesting counterpoint to the Fin’s (completely untrue and quite outrageous) slur.
Surely for the RBA to have postponed its rate rise would have been to engage in exactly the subterfuge about inflation becoming a problem that the Fin accused Treasury and in particular Treasury head Ken Henry of doing.
There was no conspiracy, there was no inflation surprise. Treasury upped its inflation forecasts even before seeing the all-important September quarter CPI numbers. And it was those CPI numbers that set inflation alarm bells ringing all over town, and especially above Martin Place in Sydney.
Self-evidently. There was no official rate rise in September or in October. But there had been in August; again a pointer to the beginning of concern.
posted on 09 February 2008 by skirchner in Economics, Financial Markets
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Peak Oilers in Simon-Ehrlich Wager
A group of Peak Oilers put their money where their mouth is:
Reveling in the role of the fly tweaking the elephant, a group of peak-oil proponents has challenged prominent oil-industry consultancy Cambridge Energy Research Associates to a not-so-friendly wager.
If CERA proves correct in its prediction that global oil production will rise by 20 million barrels per day by 2017, then the challengers, the Association for the Study of Peak Oil & Gas, will hand CERA a check for $100,000 nine years hence. If oil production falls short of CERA’s projection, as the group known as ASPO projects, ASPO will get the bragging rights and the check – and donate the money to charity.
CERA, the Boston-based company headed by prominent consultant Daniel Yergin, forecasts that global oil-production capacity could rise to 112 million barrels per day in 2017. Today, according to CERA, capacity is about 91 million barrels.
“That’s a vision in search of reality,” Steve Andrews, co-founder of ASPO’s U.S. branch, said in a statement it sent out yesterday. Who knows whether ASPO’s finances will peak before then. But along with its press release, ASPO sent a copy of what it said is a bank letter of credit guaranteeing its $100,000 bet.
While it’s scary to think the peak oilers have this much money to throw around, their willingness to back their view with an Ehrlich-Simon type bet is praiseworthy. Having said that, the criticism of peak oil does not necessarily turn on specific outcomes for oil production, but on whether a prospective peak in production has any long-term relevance.
posted on 08 February 2008 by skirchner in Economics, Financial Markets
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The Revenge of the Revenue Hoarders
The legislation to implement the government’s promised tax cuts will be introduced to parliament next week, but like a zombie army immune to intelligent argument, the advocates of increased Commonwealth revenue hoarding are not beaten yet:
WAYNE Swan has called an end to the Howard government policy of returning excess budget surpluses as tax cuts, saying the Reserve Bank had been allowed to shoulder too much responsibility for controlling inflation with interest rate rises.
The Treasurer said that under the Rudd Government, any windfall revenue would be allowed to mount up as a larger budget surplus and would be quarantined, either with the Reserve Bank or the Future Fund.
“We will be banking any upward revisions to revenue, if they occur,” he told The Australian.
Mr Swan said the previous government placed too much emphasis on the use of interest rates - or monetary policy - to control inflation, and did not do enough to control the budget with fiscal policy.
“Monetary policy is a blunt instrument and that is why it is really important that fiscal policy plays a bigger role,” he said.
This has things exactly backwards. It is fiscal policy that is the blunt and unwieldy policy instrument and Australia’s current inflation problem is first and foremost a failure of monetary not fiscal policy.
Increased Commonwealth revenue hoarding also runs counter to Treasury advice, which points to the positive implications for labour supply and potential output of lower taxes. If the previous government had not cut taxes, labour market constraints would be an even greater threat to inflation and interest rates than they are now. By contrast, Commonwealth revenue hoarding has no pay-off in augmenting the supply-side of the economy.
posted on 08 February 2008 by skirchner in Economics, Financial Markets
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Australia’s Fiscal Gang Problem
Finance Minister Lindsay Tanner says ‘Australia has a gang problem, and I’m part of it.’ He is referring, of course, to the ‘razor gang.’ Tanner was announcing a ‘modest down payment’ of $643m in budget cuts, ahead of larger cuts to be announced in the May Budget. No doubt the aim of this announcement is to be seen to be doing something about inflation in the week of an increase in official interest rates. Among the causalities are some of the former government’s more outrageous pork-barrelling projects, including the Fishing Hall of Fame and the National Rugby Academy.
The more significant cuts will take longer to put together, but the returns to what has supposedly been a line-by-line examination of government spending programs are already looking rather paltry. They are also small relative to the enormous amount of political capital the government has available to spend in the wake of its election victory. One suspects that the legendary Lu Kewen could literally spit on some voters at the moment and still have them come away thinking it was a religious experience. When it comes to cutting spending, there is no time like the present.
We previously noted that the new Labor government’s target for the underlying cash surplus of 1.5% of GDP for 2008-09 was not exactly ambitious, merely maintaining the status quo on recent budget outcomes and representing only a small contractionary impulse on forward estimates that probably would have been bettered anyway. The ugly reality for the government is that Commonwealth fiscal policy is already the tightest it’s been in two decades and further spending cuts of the magnitude being contemplated by the government will not put a dent in inflation or interest rates.
posted on 07 February 2008 by skirchner in Economics, Financial Markets, Politics
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Hot Ladies Talk Money with Bald Dudes
Jon Stewart’s take on financial TV.
posted on 07 February 2008 by skirchner in Economics, Financial Markets
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Building Approvals, House Price Inflation and Rents
If you thought the double-digit annual growth rates for established house prices in the December quarter were impressive, then you should be even more impressed with the December building approvals release. Private house approvals fell off a cliff, with the overall level of approvals at its lowest since September 2005.
In financial markets, it is common to give the building approvals release a demand-side interpretation, but the supply-side implications are more compelling in the current environment. The strong increases in dwelling rents, a direct contribution to CPI inflation, and house prices are symptomatic of a national shortage of dwelling stock which, on these numbers, is not about to be eased any time soon. Of course, rising rents and house prices should eventually induce an increase in approvals and supply. The November release seemed to herald exactly that, but those gains and more were given away in December. It remains to be seen how much of this is just one-off month on month volatility. The fact that Christmas fell on a Tuesday may have been a factor. There would not have been many people working Monday and, knowing council workers, it is hard to imagine too many hanging around on the previous Friday afternoon either, so there may be a trading day effect that is not picked-up by the usual seasonal adjustment process.
In any event, together with yesterday’s increase in official interest rates, the implications for housing affordability are fairly dire. During the previous boom in house prices earlier this decade, many people decried the tax breaks on investment property and predicted massive over-supply and a subsequent crash in property prices. Yet at best we saw a flattening in prices at the national level, suggesting that the national housing market was never seriously oversupplied. In the absence of the augmentation of the housing stock that we saw as a result of the previous boom and the concessional tax treatment of capital gains on investment property after 1999, the supply situation, housing affordability and inflation outcomes may have turned out even worse than they are now.
posted on 06 February 2008 by skirchner in Economics, Financial Markets
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