More pain for Australia

April 4th, 2007

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By the time you read this, the interest rate decision by the Reserve Bank of Australia (RBA) would have been announced. For us, we were writing this article before the announcement. Therefore, we were not in the position to know RBA?s decision. Nevertheless, our opinion is that the timing of interest rate rise is not important. What are more important are the underlying economic forces that make a rise inevitable.

From our observation of the market, we find something rather amusing. Before the RBA?s decision, the market was embroiled in a flurry of tealeaves examination activities in its attempt to divine what the RBA would do with the interest rates (see Economists punt on Aussie interest rates). The funny thing is, the RBA probably did not know what its decision would be until it was made. That was the purpose of having the meeting in the first place?to decide on something that had not been decided yet! If the RBA did not know what its decision would be, how on earth can the others know for sure? That is why we called any of such ?prediction? a punt.

Anyway, let us go back to the main point of this article. What will be the outlook for interest rates in Australia? To answer this question, we need to have an opinion on the outlook for price inflation in Australia. This is because one of the major mandates of the RBA is to achieve ?low and stable inflation over the medium term? (see the RBA?s web site). The main tool that the RBA is using to achieve its mandate is the setting of interest rates.

What is our view on price inflation in Australia? As we have said before more than a month ago in Have we escaped from the dangers of inflation?, we doubt it is a problem that can go away quietly. At this stage of the business cycle, Australia?s productive capacity is already at its peak (see Where are we in the business cycle?). Also, despite the interest rates rise since 2003, Australia?s monetary policy is still ?loose? (see What makes monetary policy ?loose? or ?tight??). If you look at the RBA?s financial aggregate figures, all measures of money supply are still expanding in the vicinity of around 12% to 14% year-on-year since 2006. From June 2003 till February 2007, Australia?s broad money supply has increased by almost 50%! This tells us that as long as Australia?s economy is ?strong,? its price inflation problems are not going to go away. Therefore, there is going to be pressure on the RBA to raise interest rates in order to truly ?tighten? liquidity in the economy.

However, there is another issue that complicates the whole thing. The risk is that with so much debt in Australia, interest rate rise can burst the debt-driven asset bubble, hurtling Australia down into a deflationary recession. But we believe it is better to burst the bubble earlier than later because any delay will result in the unavoidable burst having a more painful impact. Unfortunately, the RBA does not have the mandate to prick dangerous bubbles.

What is the implication of this?

It means that given the mandate constraint imposed on the RBA, it can only raise interest rates to ?fight? price inflation (the idea of a central bank ‘fighting’ inflation is flawed- see Cause of inflation: Shanghai bubble case study). Consequently, asset price bubbles will be allowed to balloon further (i.e. ?loose? money) as long as price inflation seems to be under control. When the inevitable bursting of the bubble happens, Australian household will bear the brunt of a severe recession.

We encourage you to read this article about this warning from Ian Macfarlane, the former RBA governor: Next economic dip will hit households.