High Noon Tuesday at the RBA

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In a Nutshell: I have a hunch that the RBA will follow its conventional “neoclassical” models and raise rates tomorrow, 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.

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The RBA meets 11 times a year to set the cash rate. At only 4 of those meetings—February, May, August and November—does it know the most recent CPI fig­ures before the meet­ing. When the Board meets tomor­row morn­ing, 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 2–3% 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” (as Aus­tralians call the Great Reces­sion) gen­er­al­ly fol­lowed what is known as the Tay­lor Rule. This rule argues that when the econ­o­my is at full employ­ment and infla­tion exceeds 2 per­cent, the Cen­tral Bank should respond to an increase in infla­tion by rais­ing rates 1.5 times as much.

Fig­ure 1: Con­sumer Price Infla­tion in Aus­tralia

Accord­ing to the Tay­lor Rule, the RBA should raise its rate to 5 per­cent if it uses its trimmed mean as the mea­sure of infla­tion, and to a whop­ping 6.4 per­cent 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 tomor­row: 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.

Fig­ure 2: The Tay­lor Rule in a Debt-con­strained econ­o­my

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 per­cent, but they kept increas­ing the rate to a high of 18 per­cent 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-WWII peak of 11.2 per­cent.

Fig­ure 3: Debt to GDP and Cred­it Growth

A cur­so­ry look at Fig­ure 3 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 (see Fig­ure 4).

Fig­ure 4: Debt to GDP lev­el and growth rate

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 per­cent of GDP back when the cash rate was 15 per­cent in the late 1980s (see Fig­ure 5). 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.

Fig­ure 5: Debt by sec­tor as a per­cent­age of GDP

Glen Stevens seemed to acknowl­edge this point in his speech “The Cau­tious Con­sumer” last week, when he said that:

“The peri­od from the ear­ly 1990s to the mid 2000s was char­ac­terised by a drawn-out, but one-time, adjust­ment to a set of pow­er­ful forces. House­holds start­ed the peri­od with rel­a­tive­ly lit­tle lever­age, in large part a lega­cy of the effect of very high nom­i­nal inter­est rates in the long peri­od of high infla­tion. But then, infla­tion and inter­est rates came down to gen­er­a­tional lows. Finan­cial lib­er­al­i­sa­tion and inno­va­tion increased the avail­abil­i­ty of cred­it. And rea­son­ably sta­ble eco­nom­ic con­di­tions – part of the so-called ‘great mod­er­a­tion’ inter­na­tion­al­ly – made a cer­tain high­er degree of lever­age seem safe. The result was a lengthy peri­od of ris­ing house­hold lever­age, ris­ing hous­ing prices, high lev­els of con­fi­dence, a strong sense of gen­er­al­ly ris­ing pros­per­i­ty, declin­ing sav­ing from cur­rent income and strong growth in con­sump­tion.

I was not one of those who felt that this was bound to end in tears. But it was bound to end. Even if one holds a benign view of high­er lev­els of house­hold debt, at a cer­tain point, peo­ple will have increased their lever­age to its new equi­lib­ri­um lev­el (or, if you are a pes­simist, beyond that point). At that stage, debt growth will slow to be more in line with income, the rate of sav­ing from cur­rent income will rise to be more like his­tor­i­cal norms, and the finan­cial source of upward pres­sure on hous­ing val­ues will abate…”

This is a wel­come acknowl­edge­ment that changes in pri­vate debt have some macro­eco­nom­ic impacts, as Rob Burgess point­ed out recent­ly in Busi­ness Spec­ta­tor (see “Steve Keen’s RBA Con­vert”). 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:

“Can we look for­ward to a time when these adjust­ments to house­hold sav­ing and bal­ance sheets have been com­plet­ed? We can… the sav­ing rate, debt bur­dens and wealth will at some stage reach lev­els at which peo­ple are more com­fort­able, and con­sump­tion (and prob­a­bly debt) will grow in line with income… We could then rea­son­ably expect to see con­sump­tion record more growth than it has in the past few years.”

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 per­cent 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.

Fig­ure 6: Cred­it Growth and Accel­er­a­tion in Aus­tralia (NB: labels are wrong way round; will amend lat­er)

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 USA. Our peak neg­a­tive from the Cred­it Accel­er­a­tor came in at minus 13%, where­as the USA’s maxed out at minus 27%–which is why the down­turn in the USA 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 USA spent two years in a severe reces­sion while Aus­tralia record­ed only one quar­ter of neg­a­tive growth.

Fig­ure 7: Cred­it Accel­er­a­tors for Aus­tralia and the USA

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.

Fig­ure 8: Pri­vate debt lev­els for Aus­tralia and the USA

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:

We can­not real­ly know, of course, when that might hap­pen…. the rise in the sav­ing rate over the past five years … was … the biggest adjust­ment of its kind we have had in the his­to­ry of quar­ter­ly nation­al accounts data… That in turn means that the time when more ‘nor­mal’ pat­terns of con­sump­tion growth recur is clos­er than it would have been with a more drawn-out adjust­ment…. It is entire­ly pos­si­ble that, were some of the cur­rent raft of uncer­tain­ties to lessen, the mood could lift notice­ably, so I don’t think we need to be total­ly gloomy.

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 USA, where growth has fall­en well below the “Okun’s Law” lev­el of 3 per­cent and unem­ploy­ment is once more on the rise.

Fig­ure 9: Real growth rates in Aus­tralia and the USA

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 tomor­row.

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.

Sky News emails on interest rates

I was very glad to have West­pac’s Bill Evans agree­ing with me that rates should fall. This is a case I’ve been mak­ing for a year now, as evi­denced by the Sky News poll on rates that I’ve con­tributed to irreg­u­lar­ly for the last year. Sky could­n’t locate a data­base of its pro­grams on the top­ic, but here is a selec­tion of my emails to Sky since mid-2010. I expect­ed rate cuts to begin before now—which clear­ly did­n’t happen—but this is in con­trast to all oth­er com­men­ta­tors who thought rates would and should rise. I thought they might—but that such a move would be a pol­i­cy mis­take.

July 2010

Hi Steve

Can’t reach you on the mobile/landline …

Com­pil­ing our rates poll ahead of tomor­row’s deci­sion. Let me know yr call on:

· Tomor­row

· Decem­ber 2010

· July 2011

Flat mate–I’m in NY right now BTW, and the glob­al roam­ing works about as well as the glob­al econ­o­my.

By Decem­ber, 0.25 to 0.5 below now.

July 2011, 0.5 to 1.0 below now.

————–

October 2010

We’re con­duct­ing our Sky News inter­est rate poll for Novem­ber, hope you can help out again.

Will we see an inter­est rate rise in November/how much?

Rates by end March quar­ter?

Year from now?

Any­thing you’re par­tic­u­lar­ly watch­ing out for Tues­day?

Thanks for your time in advance,

Again it’s the old Chan­gi game–betting which cock­roach will cross a line first–but I think the RBA will hold off again because of the “unex­pect­ed­ly low” infla­tion num­bers this week (inci­den­tal­ly I’m one of the few expect­ing such num­bers because I think we’re head­ed for defla­tion glob­al­ly, not infla­tion).

The RBA is itch­ing to put rates up though, and they may well make up a rea­son for putting rates up by 0.25 at some time between now and Feb­ru­ary.

How­ev­er I’ll go with rates at 4.5% in March (unchanged) and below 4% in a year from now–not 3% as I have been call­ing for a while, but low­er rather than high­er.

—————–

February 2011

Good after­noon,

Time for our month­ly inter­est rate poll, hope you can spare us a moment.

Will the RBA move on inter­est rates/by how much?

No.

Where will rates stand the end of June quar­ter?

Same as now: 4.75%

One year from now?

Low­er: of the order of 4%.

What com­ment are you most look­ing for­ward to in the state­ment?

Sur­prise about the fail­ure of infla­tion to hit the lev­els they were expect­ing. The last few CPI fig­ures have come in below their expec­ta­tions, mean­ing that the tight­en­ings they did in the antic­i­pa­tion of high­er infla­tion have not been jus­ti­fied by the actu­al per­for­mance of the CPI.

—————-

May 2011

Hel­lo,

Hard to believe it’s almost May – I hope you don’t mind tak­ing a few moments to com­plete this mon­th’s sur­vey.

Will we see a rate change on Tuesday/by how much?

Where will rates sit by the end of the Sep­tem­ber quar­ter?

May next year?

What are you look­ing for in the state­ment?

Many thanks again,

No change, though if they’re spooked by the recent CPI they might raise by 0.25.

Sep­tem­ber: 0.25 low­er than now

May next year: below 4%

The state­ment: Some puz­zle­ment about the low rate of growth of cred­it; con­tin­ued euphor­ic expec­ta­tions about Chi­na; more neglect of the “Dutch Dis­ease” dan­gers posed to man­u­fac­tur­ing and tourism from the high dol­lar.

—————

June 2010

Hel­lo,

Hope you can spare a moment to answer our month­ly inter­est rate poll.

Will the RBA hike OCR tomorrow/by how much?

Where will rates be at the end of the Sep­tem­ber quar­ter?

June next year?

What will you be look­ing out for in the state­ment?

I expect them to keep rates on hold, but they could be brazen and increase them because their mod­els tell them they have to “strike first” to fight the infla­tion their mod­els pre­dict.

It would be a mis­take for them to do so, but far be it from me to argue that the RBA does­n’t make mis­takes!

I think rates might be at 5% by Sep­tem­ber and 4% or low­er by this time next year.

————–

July 2011

Hel­lo,

Inter­est­ing times – hope­ful­ly you can spare a moment to com­plete this mon­th’s inter­est rate poll by Mon­day after­noon.

Will there be an inter­est rate rise in August/by how much?

OCR by the end Decem­ber?

OCR in August (post meet­ing) next year?

What’s the main point you’ll be look­ing for in accom­pa­ny­ing state­ment?

I’ll write a post this week­end called “Blue Moon Tues­day at the RBA” because it’s only once in a blue moon that their deci­sion comes soon after the CPI change is known, rather than before.

I think they’ll hike 25 points on Tuesday–not because they should but because their “Tay­lor equa­tion” mod­el tells them they should to stop infla­tion in its tracks.

The trou­ble is they also know that house prices are falling and growth is slow­ing in the US and Europe. So I think they’d rather not put them up, but for their own cred­i­bil­i­ty as “infla­tion fight­ers” they’re almost forced to.

I see that as an error, but it’s one I think they’ll make.

For the future, I think the econ­o­my will go fur­ther backwards–accelerated by the .25 rate increase’s effect on house prices and households–and they’ll be forced into reverse.

So a 5% cash rate by Tues­day, 4.5% by Decem­ber and below 4% by next August.

In the state­ment I expect a con­fused inter­na­tion­al out­look, recog­ni­tion of the 2 speed econ­o­my, and a “bal­ance of prob­a­bil­i­ties” call that the uptick in infla­tion jus­ti­fies the rate hike.