Monetary Policy Lessons from Australia

Just over 3 months ago it was: Australia’s “Miracle Economy” Running out of Tricks:

Australians are slowly coming to the realization that their miracle economy, which on Wednesday marked 23 years without a recession, might not be so blessed going forward.

A mining investment boom that has sustained the economy for the past decade remains a key growth driver but like a fading star its fuel will soon run low, it will dim and eventually it will flame out.

The Reserve Bank of Australia has thrown eight interest-rate cuts at the problem over the past two years, hoping other parts of the economy will rise to fill the void.

So far, however, the tonic has had little result: Gross domestic product grew 0.6% on-quarter in the third quarter of the year, slower than the prior period, data Wednesday showed. The economy grew 2.3% compared to a year earlier, well below its 3.0% long-term average and economists’ forecast of 2.6% growth. The RBA is predicting growth of just 2%-3% next year.

Mining remained a key driver of growth in the third quarter, but other parts of the economy were quiet. The temperature under house prices has risen a few degrees, while credit has begun to flow more easily. Business confidence has risen, but how long that will last is anybody’s guess.

Now it seems that New Zealand is the “leader of the rate rising pack”:

The Reserve Bank of New Zealand’s interest rate rise has cemented its status at the head of the developed world’s economic cycle, but Australia’s huge jobs gain means it may not be far behind.

The RBNZ raised the cash rate one-quarter of a percentage point to 2.75 per cent on Thursday, as expected, before Australian employment figures showed the best jobs growth in two years, with 47,000 new positions created during February. The employment data suggests the jobs market has caught up with the acceleration in the rest of the economy and resolves a worrying lag.

New Zealand is further ahead (in what, rate rising ‘contest’?) of Australia, thanks to a terms-of-trade boom that is underpinned by demand for Kiwi dairy exports, mostly attributed to China and India. RBNZ governor Graeme Wheeler said: ”By increasing the [official cash rate] as needed to keep future average inflation near the 2 per cent target mid-point, the bank is seeking to ensure that the economic expansion can be sustained.”

Let´s pause and look at their respective monetary policy statements.

Australia

The Reserve Bank is responsible for Australia’s monetary policy. Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation.

In determining monetary policy, the Bank has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term.

New Zealand

The Reserve Bank uses monetary policy to maintain price stability as defined in the Policy Targets Agreement (PTA). The current PTA requires the Bank to keep inflation between 1 and 3 percent on average over the medium term, with a focus on keeping future average inflation near the 2 percent target midpoint. The Bank implements monetary policy by setting the Official Cash Rate (OCR), which is reviewed eight times a year.

While New Zealand´s ‘purpose’ is solely concerned with the inflation target, Australia mentions, in addition, “economic prosperity and welfare of the Australian people.”

They both say that they implement monetary policy by juggling the cash rate. So let´s check who has ‘juggled best’.

The panel below shows the official rate moves, the real growth rate and inflation since 1992.

Australia Lessons_1

Australia Lessons_1A

Highlights:

The policy rate in Australia swings much less than in New Zealand. Maybe this is reflected in the higher and much smoother real growth in Australia and in the fact that Australia inflation, over the last 12 years has fluctuated much closer to its target mid-point than in New Zealand.

The Asia crisis provides a marvelous example of monetary policy competence by Australia. Both countries were victims of the same exogenous shock (a strong drop in commodity prices). That´s a real and deflationary shock; nevertheless New Zealand thought that the resulting depreciation of the Kiwi dollar presaged inflation. Later it realized the grave mistake made!

But some know that interest rates are not good indicators of the monetary policy stance. A better gauge is to observe the behavior of NGDP relative to its trend. The implication for the behavior of monetary policy is the same as before. The chart says it better than words!

Australia Lessons_2

So it is Australia, not New Zealand who is ahead of any other advanced economy in the only game that matters, to wit, obtaining nominal stability. The so-called “huge jobs gain” is a welcome sign with no direct implication for interest rates.

If only others were to decide to follow on Australia´s footsteps, there would be no need for Schadenfreud!

Update (March 17):

SYDNEY–Australia’s central bank expects interest rates to remain at record-low levels for a while as the economy endures a slowdown in mining investment, minutes of its last meeting published Tuesday showed.

“The cash rate could remain at its current level for some time” if economic expectations play out, according to the minutes from the central bank’s policy meeting earlier this month. “The most prudent course was likely to be a period of stability in interest rates.”

One thought on “Monetary Policy Lessons from Australia

  1. Pingback: Interest Rate-inflation targeting swan song | The Corner

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