Sent: 02-09-2008 10:58:01
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Will Monetary Policy be Too Timid?
The widely expected decision by the Reserve Bank today to cut official interest rates by 0.25% is probably wrong.
The Reserve Bank has flagged an announcement today that it will cut interest rates for the first time in seven years.
The bank is apparently being forced to act by signals that Australian economic growth is decelerating quickly presaging a reduction in inflation. Barely a few months ago, Australia's ties with Asia were expected to sustain its growth and labor and infrastructure shortages were thought likely to limit how quickly inflation would retreat.
That view has been turned on its head.
Inflation remains high and beyond the bounds set by the Reserve Bank. None of the medium term structural problems contributing to its acceleration have been solved. It is far from clear that the inflation genie is back in the bottle.
There is some argument that the currently heightened inflationary pressures are beyond the power of the Reserve Bank to counter. On this view, it can do little in any case. Whatever the arguments on that point, however, the current inflation rates are beyond what the Reserve Bank had defined as acceptable.
The T D Securities inflation indicator for August, released this week, showed a slight fall. This could have been construed as some lessening of the pressure. However, the fall, such as it was, was largely attributable to lower oil prices during the measurement period. Without that effect, inflation would have been moving higher, suggesting that the pressures have not yet started to ease. They may be worsening.
Taken in isolation, these conditions would probably have justified further interest rate rises over the coming 12 months notwithstanding the additional hardship they might have imposed.
Policy is now being driven by the deflationary threat emanating from the U.S. debt crisis. The already known impacts of this powerful phenomenon still have some way to run. But there are potentially more, still unknown, negative shocks to come from U.S. financial institutions creating more fears among Australian policy makers and many commentators.
Not only might U.S. conditions deteriorate but there is scope for a wider ripple effect. There has been little sign so far of deteriorating U.S. and European conditions feeding back to China, for example. While a growing proportion of China's growth is self-sustained, this economy cannot quarantine itself indefinitely from less propitious conditions in the more developed economies.
In both prospective scenarios - high inflation and low growth - fear of the consequences rather than current conditions is driving the reaction. Right now, our collective minds have made low growth the more worrying outcome. Gone are the admonitions from politicians to leave interest rates to the Reserve Bank. Everyone is giving advice to cut rates. But the decision is not clear-cut.
As always, when we are uncertain about the direction to move, there is some temptation to stay in the middle ground. In this context, finding it difficult to choose between two economic scenarios, there will be a temptation to loosen policy just a little with a small 0.25% change and a determination to wait for further information.
If we are right about the forces in play, this decision will probably be wrong: not enough to cope with a set of global deflationary forces which are still being unleashed and, if that is proven to be an exaggerated fear, the wrong direction to cope with inflation. We will have handled neither problem adequately.
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