Sent: 22-09-2009 14:47:01
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What is Normal?
Interest rates should return to normal levels according to many commentators. But what is normal and will it ever happen again?
Australia's Reserve Bank and many market commentators are discussing a return to more normal interest rate settings. A cash rate of 6% is referred to as being closer to the norm than the currently prevailing 3%.
Around the world, finance ministers are considering how to revert to normal fiscal conditions. There is a consensus that current deficits should be maintained for the time being but there is agreement that they should be hauled back to something more normal.
Unfortunately, the economic body is not like the human body with a universally recognized normal body temperature of 37°C. Significant departures from the normal body temperature are unambiguous danger signs and there is no argument over a return to normal being a good thing.
In economics, there is no such immutable target. There can be an infinitesimal number of acceptable combinations and a similar number of undesirable outcomes. An appropriate level of interest rates, for example, could be anything from a 0% to 20% depending on what is happening to other economic variables.
In Australia, the average cash rate since 1960 has been 7.3%. However, that average has traversed inflation as high as 18% and as low as zero, an exchange rate that moved from 148 to 50 U.S. cents and average output growth of 3½% which was the product of several recessions and peak output growth of 8%.
A year ago, we saw a set of economic outcomes many standard deviations from the norm even while policy settings were close to average. The a priori probability of such a combination of circumstances would have been extraordinarily low.
The mere fact that those events transpired means that policy must now be conducted with one eye on the possibility that such a catastrophe once again emerges as a threat. To the extent that such outlier events influence our thinking, historical averages can no longer act as a guide to what constitutes sound policy.
In the past week in Australia, the Commonwealth Treasurer announced that his department had reappraised Australia's population growth outlook. Population growth rates are now expected to rise from the previously anticipated 0.7% a year to 1.2% between now and 2049 resulting in an additional 7 million people than previously anticipated.
Subject to changes in the labor force participation rates, population growth sets the tone for national output growth. Australia can now expect stronger output growth than, for example, the 2% rate of growth projected in the last Intergenerational Report prepared by the Treasury. A higher population growth rate also implies that interest rates should generally be higher. Of course, the extent to which interest rates have to be adjusted will also depend on how domestic productivity growth changes in response to the change in the rate of population expansion.
Another consideration is international monetary settings. If the European, U.S. and Japanese central banks set interest rates to help keep asset prices aloft, as they have been prone to do especially in the USA, Australia will be unable to withstand the pressure. Its asset prices will react similarly. Genuinely offsetting policy could require very high unemployment inducing interest rates.
Unemployment levels are going to be a key test for policy settings. The current consensus is for global growth in the coming 10 years to be slower than in the previous 10 years. Unemployment rates will struggle to decline under this scenario leaving pressure on policymakers to keep employment supportive policies in place.
Among the lessons of the past year is the need to identify and manage risks. As a community, we might decide that the risk of inflation, for example, is not as great as the risk of widespread high unemployment.
If inflation emerges, we know how to react: raise interest rates quickly and forcefully. However, we are on a less sure analytical footing in understanding the connection between monetary policy and employment growth. Monetary policy is less effective in supporting employment than in cutting inflation. Since the connection between inflation and interest rates is relatively clear-cut, we might be able to afford to wait for the evidence to mount before taking anti-inflation action rather than risk a detrimental employment effect.
Being more acutely aware of the risks after our 2008 experiences may require a different policy balance going forward. Inflation first, the slogan behind the policies of the last 20 years, might give way to a greater emphasis on employment growth if the current consensus becomes reality. What becomes normal cannot be divorced from contemporary priorities.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.