I have a hunch that the RBA will follow its conventional “neoclassical” models and raise rates this afternoon, even though the economy is locked in “two speed” mode, and the global economy is racked by uncertainty.
This would be a mistake. Given unprecedented private debt levels and deleveraging by households and businesses, a rate rise would accelerate the economy’s decline into recession.
The RBA meets 11 times a year to set the cash rate. At only four of those meetings – February, May, August and November – does it know the most recent CPI figures before the meeting.
When the Board meets today, it knows that consumer price inflation was 3.6% for the year. Even the RBA’s preferred trimmed mean, which shows a lower annual rate of 2.7%, has had two consecutive quarters of 0.9%.
Inflation is thus above the RBA’s target zone of 2% to 3% on one measure, and heading that way on another.
On inflation alone, the RBA is therefore under strong pressure to raise rates.
As a very conventional central bank, the RBA’s policy decisions before the global financial crisis generally followed what is known as the Taylor Rule.
This rule argues that when the economy is at full employment and inflation exceeds 2%, the central bank should respond to an increase in inflation by raising rates 1.5 times as much.
According to the Taylor Rule, the RBA should raise its rate to 5% if it uses its trimmed mean as the measure of inflation, and to a whopping 6.4% if it uses the standard CPI.
It’s inflation High Noon, the Price Rise Gang is in town, and the Sheriff has to kill them with his anti-inflation Colt 45.
As the Gary Cooper of Central Banks, the RBA therefore simply has to raise rates today. To do otherwise would be cowardice.
That’s if you believe that the Taylor Rule actually describes reality — I categorically don’t.
The only arguments in the Taylor Rule are the policy interest rate, the inflation rate (actual and target) and the growth rate (actual and target).
Like all neoclassical models, it ignores the role of private debt in the economy. Now that private debt is falling from unprecedented levels in Australia, two factors that aren’t even considered by the RBA’s exclusively neoclassical economic models are really determining the economy’s direction – the level of debt that is constraining consumers, and deleveraging by both households and firms that is reducing aggregate demand.
Pulling the interest rate trigger may blow the economy’s (and the Sheriff’s) brains out.
The RBA thus faces a dilemma: if it sticks with its “fight inflation first” motto, it could trigger a much sharper slowdown in the economy than its models predict.
This isn’t the first time the RBA has faced this dilemma.
Back in the late 1980s, credit growth was astronomical, and the economy was going gangbusters. After dropping rates in the aftermath to the Stock Market Crash of 1987 — and introducing the First Home Owners Scheme which kick-started a property bubble — the policy makers (interest rate setting wasn’t the exclusive domain of the RBA back then) put up interest rates to constrain the boom.
Their timing was bad: the boom in credit ended at the start of 1989 when the cash rate was 15%, but they kept increasing the rate to a high of 18% by 1990.
A year later, credit growth was negative on a monthly basis (though still positive year-on-year), and the RBA was in serious backpedal mode, dropping interest rates as the economy fell away beneath it in “the recession we Had to have”.
During the recession itself, annual credit growth actually turned negative, and not merely coincidentally, unemployment rose to a post-Second World War peak of 11.2%.
A cursory look at the chart above might make you think that the RBA has less of a problem this time. Credit growth is lower, and though it approached zero back in 2010, it had bounced from that level; and interest rates now are substantially lower than in 1989.
But that is misleading, because though credit growth is lower, credit growth is much larger compared to GDP than it was then—because debt has grown so much more than GDP.
Though the rate of growth of credit was much lower in the last decade than it was in the 1980s—a peak growth rate of under 18%, versus an average of over 18% for 1980-1990 — the contribution that credit growth makes to aggregate demand is much larger today, because private debt is so much higher.
Credit growth averaged 9.5% of GDP in the 1980s, versus 13.5 percent from 1998 till 2008
This has two implications. The first, relatively obvious one, is that consumers are debt-constrained as never before, and are therefore not spending. Household debt was less than 25% of GDP back when the cash rate was 15% in the late 1980s.
It is now almost 100% of GDP—four times as high. Therefore, even ignoring the impact of repaying principal, an RBA rate of 4.75% today equates to 19% back then.
Households are thus even more strained today than they were when the cash rate was 18 percent in 1990 — and inflation today is a lot lower than it was in 1990, which makes the real debt service burden today even worse.
So the level of household debt is a major factor in the subdued level of household consumption.
Glenn Stevens seemed to acknowledge this point in his speech “The Cautious Consumer” last week, when he said that changes in private debt have some macroeconomic impacts – a point Rob Burgess noted recently in Business Spectator.
But it is not enough: Stevens is still thinking in neoclassical terms, where everything settles down to “equilibrium”, and he has not integrated credit into his thinking.
Though he obliquely acknowledges that rising debt boosted aggregate demand, he doesn’t make the leap to see that aggregate demand is the sum of GDP plus the change in debt.
Stevens is hoping that once the “drawn-out, but one-time” change in household leverage settles down, tranquil growth in income and consumption will return.
But this can only happen if aggregate demand grows smoothly, which it can’t do unless debt not merely grows, but accelerates.
This is so because, since aggregate demand is GDP plus the change in debt, the change in aggregate demand is the change in GDP plus the acceleration of debt.
Accelerating debt is thus necessary for a constant rate of growth of aggregate demand, but if debt continually accelerates, it must ultimately grow faster than GDP.
This is what happened in the period from 1993 till 2008 – when the RBA, like central banks around the globe, ignored the role of private debt even as the biggest debt bubble in history developed, because their neoclassical models of the world ignored the role of credit.
The acceleration in debt averaged over 2% of GDP in Australia between 1993 and 2008, so much of the recorded 3.8% growth in output over that period—and most of the growth in asset prices—was driven by accelerating debt.
The GFC began when accelerating debt rapidly turned into decelerating debt. Australia attenuated the severity of the downturn partly by encouraging households back into debt with what I call the first home vendors boost, so that even though the deceleration in debt was severe, it wasn’t nearly as severe as in the US.
Our peak negative from the credit accelerator came in at minus 13%, whereas the US maxed out at minus 27% – which is why the downturn in the US was so much worse than in Australia.
Secondly, again under the influence of the first home vendors boost, our credit accelerator turned positive again before it did in America — so the US spent two years in a severe recession while Australia recorded only one quarter of negative growth. See the chart below.
But herein lies the rub. Both countries now face the same problem that, with private debt levels at unprecedented highs, debt will normally tend to decelerate rather than accelerate, and this deceleration could go on for a very long time.
America’s level has already fallen by 40% of GDP since its peak in early 2009, and the current massive increase in the credit accelerator is due to a slowdown in the rate of growth of debt while debt is still falling.
Having delayed its deleveraging via the first home vendors boost, Australia is only just starting to delever—and its Credit Accelerator is now turning negative after an anaemic rise till the end of 2010.
This is the major cause of the “two-speed” economy—with the retail sector and non-mining States stuck in reverse—and it won’t end until private debt levels fall substantially from today’s levels.
For this reason, I don’t share Stevens’ optimism that this downturn in consumer spending will prove to be brief.
However I do agree that the “new normal” won’t be as strong as the “old normal”. But what is “normal”? Will the “good old days” for consumption growth of the 1995‑2005 period be seen again?
I don’t think they can be, at least not if the growth depends on spending growth outpacing growth in income and leverage increasing over a lengthy period.
To that reason, I add the probability that the credit accelerator will remain negative for most of the next decade, with the consequence that the economy will not benefit from the legitimate role that expanding credit plays in a growing economy — when that credit is used to finance investment rather than Ponzi Schemes.
Consequently both Australia and America are likely to return “disappointing” growth figures: growth will tend to be below the 3% level that is needed to reduce unemployment. This is already firmly the case in the US, where growth has fallen well below the “Okun’s Law” level of 3 percent and unemployment is once more on the rise.
Thus the “Taylor Rule” advice that the RBA should raise rates is extremely bad advice—but there are reasonable odds that the RBA will follow it and raise rates this afternoon.
The impact of such an increase will be dramatic, and will amplify the case I have been making for a year now, that the RBA will be forced by economic circumstances to abandon its “fight inflation first” obsession, and cut rates to stimulate a flagging economy.