After a decade in which Australia’s central bank has only moved its cash rate in one direction (down) while trying to ignite inflation, it is now poised to push its cash rate up in a bid to douse those flames.
Central banks hunt in packs – partly because they face the same problems, partly because they are advised by the same sort of economists, and partly because they are, in the words of The Kinks, dedicated followers of fashion.
Inflation has spiked and central banks have pushed up their versions of the cash rate in the United States, the United Kingdom, New Zealand, Canada and elsewhere. So there’s a very good chance we will too.
Apart from anything else, if we didn’t push up our rates when other countries were raising theirs, our currency would sink. So there’s mileage in running with the pack, even if we later discover the pack has been running in the wrong direction.
From the 1940s to the 1970s, central banks kept interest rates low, relying on heavy financial regulation to limit borrowing, and on fixed or regulated exchange rates to control the value of their currencies.
They found high interest rates an ineffective tool, partly because governments had just deregulated financial institutions and private banks kept creating money, regardless of how high the central banks pushed up interest rates.
Monetarism, then inflation targeting
These at least got inflation back down, even though the inflation genie temporarily escaped from its bottle again in the late 1980s, leading to further hikes in interest rates and another set of recessions.
“Why hadn’t they thought of that before?” you might ask.
All about the cash rate
The cash rate is the average rate banks pay to lend to each other overnight.
Careful readers will have noted that it is the banks themselves, rather than solely the Reserve Bank, that determine the rate, although the Reserve Bank administers the system though which the trades are made.
the Reserve Bank proposes to operate in the domestic money market this morning with a view to reducing cash rates
By borrowing enough from or lending enough to the private banks, the Reserve Bank could almost always push the cash rate up or down to where it wanted it.
So successful was it in getting the cash rate where it wanted, and so successful did the banks know it could be, that after a while it didn’t need to trade in the market to do it.
the board decided to increase the cash rate by 25 basis points
Australia’s Reserve Bank adopted an inflation target of 2-3%, “on average, over time”. Other central banks adopted different targets. New Zealand’s target was originally 0-2% and was later lifted to 1-3%. The United States, United Kingdom, European Union and Japan target 2%. Canada targets 1-3%.
Regardless of the exact target, and regardless of the countless times it has been missed, inflation, and expectations of inflation, have stayed low ever since.
It mightn’t be because of the interest rate adjustments, and certainly isn’t only because of them. Other candidates include insecure employment, globalisation, growing inequality and cheap energy; but central bankers like to take the credit.
In 2004, Ben Bernanke, later to become Chair of the US Federal Reserve, spoke of a Great Moderation and said that in his opinion it wasn’t just luck, but the skill of modern central bankers that had brought it about. They had finally cracked it!
Inflation tamed, til it wasn’t
What you might not have heard is that two years later it was half that level, because of the 2008 global financial crisis, which had been around the corner during the election when the rate was hiked.
But the flood of money the Reserve Bank pushed out the door by buying government bonds and lending to banks for next to nothing pushed the actual overnight cash rate down even lower, beneath 0.1%, to close to zero.
Official rates in Europe and elsewhere had been negative before the pandemic.
In much of the rest of the world what Australians call the global financial crisis was called the “great recession”, and central bankers threw everything they could at trying to restore inflation after it was over.
They failed, just as Australia’s central bank failed to restore inflation. When COVID struck, inflation had been below the bottom of the Reserve Bank target band for almost all of the previous half decade.
This wouldn’t have been a surprise to the iconic 20th-century economist John Maynard Keynes, who is said to have once compared trying to boost an ailing economy by cutting interest rates to “pushing on a string”.
Cutting rates can’t force unwilling businesses and consumers to invest and spend.
What it should tell us is that the relationship between the cash rate and inflation is more complex that the central bankers told us (and themselves) it was. Hiking interest rates far enough will almost certainly bring inflation down, but at a cost.
Rate hikes can be counterproductive
Small increases in interest rates can actually push prices up. Interest rates are a cost to businesses (and to landlords) and can be passed on in prices.
And while pushing up rates reduces the disposable income of those with mortgages to repay (putting downward pressure on spending and prices) it raises the spending power of people such as myself, with savings in term deposits, boosting our ability to spend and push up prices.
Higher interest rates are often thought to discourage business investment, but there is little evidence they do. Investments are driven more by expected sales than the cost of finance.
What would bring inflation down would be a series of interest rate hikes so big it crashed property and share market prices, or so big it pushed people out of work and brought on a recession.
So the central bank pack ought to tread carefully. If inflation is driven by fossil fuel prices, supply chain disruptions, wars and (looking ahead) climate change, then showing restraint, and addressing the causes of these issues or waiting for them to pass might be a better response than pushing up rates, albeit not one in the central bank tool box.
The best bands don’t play solo
And we ought not forget that central banks and regulators have another tool they can use, which is to tighten the amount of credit by limiting how much financial institutions can lend. Higher interest rates are one of the instruments in the band, but not the only one.
Bands sound better when they are made up of several players, playing several instruments. If you are performing solo, you need to be extremely good.
- ^ unwelcome way (theconversation.com)
- ^ down (www.rba.gov.au)
- ^ dedicated followers of fashion (youtu.be)
- ^ heavy financial regulation (www.richmondfed.org)
- ^ Elia Zanrosso/Pexels (www.pexels.com)
- ^ 1973 (www.federalreservehistory.org)
- ^ 1979 (gearsofhistory.com)
- ^ monetarism (www.investopedia.com)
- ^ recessions (bancroft.berkeley.edu)
- ^ another set of recessions (en.wikipedia.org)
- ^ targeting inflation itself (www.rba.gov.au)
- ^ cash rate (www.rba.gov.au)
- ^ early announcements (www.rba.gov.au)
- ^ things like (www.rba.gov.au)
- ^ basis point (www.investopedia.com)
- ^ 2-3% (www.rba.gov.au)
- ^ 0-2% (www.rbnz.govt.nz)
- ^ 2% (qz.com)
- ^ 1-3% (www.bankofcanada.ca)
- ^ Inflation hits 5.1%. How long until mortgage rates climb? (theconversation.com)
- ^ Great Moderation (www.federalreserve.gov)
- ^ skill (www.federalreservehistory.org)
- ^ 2007 (www.smh.com.au)
- ^ What's in the CPI and what does it actually measure? (theconversation.com)
- ^ increasingly risky financial behaviour (www.thebalance.com)
- ^ down, down, deeper and down (youtu.be)
- ^ 0.1% (www.rba.gov.au)
- ^ government bonds (theconversation.com)
- ^ next to nothing (www.rba.gov.au)
- ^ great recession (www.federalreservehistory.org)
- ^ Don't look Up! has a lot to say about economics, much of it useful (theconversation.com)
- ^ pushing on a string (www.investopedia.com)
- ^ Of the 4 economic wildcards between now and voting day, the first is CPI (theconversation.com)
- ^ fiscal (www.investopedia.com)
- ^ cost of living bonus (www.abc.net.au)
Authors: Steven Hail, Adjunct Associate Professor, Torrens University Australia