Why the RBA Was Misguided in Cutting Interest Rates

Monetary policy is used to help economies flourish. Back in 1968, a famous economist, Milton Friedman, published one of his more known papers, ‘The Role of Monetary Policy’. As many of us find it hard to conceptualise economic theory, Friedman divided his paper into three parts. The first was explaining what two things monetary policy cannot do.

The first is that monetary policy cannot peg interest rates for more than very limited periods.

Friedman draws on many arguments for why monetary policy cannot peg interest rates. He first used the example of when, post-war, the US started pegging bond prices. When the Federal Reserve tried to keep rates down, they bought securities (bonds). By doing this, they inevitably raised bond prices, while lowering their yields. Therefore the interest rate of the bond is lower.

How does this work?

Since there’s more demand for bonds, prices increase. And because the price of a bond and the yield of a bond are inversely related, yields start to retreat. Lowering the interest rate, or offering lower bond yields, will then essentially increase spending in the economy. Now businesses and consumers have to pay less for borrowing money.

The whole point of this is to increase the total quantity of money. By lowering interest rates, central bankers want businesses and the public to spend more. And the more rapid the rate of monetary growth, the more rapidly that spending increases too…both through increased investment and spending.

The same thing happens when your income increases. Once you earn more money, you usually tend to buy more stuff. Either you need a new phone, car, house, clothes or you just want to take a holiday. The more money you have, the more likely you’ll increase your spending.

But as prices start to rise, the quantity of money actually declines. No longer can you buy luxurious items because they now cost more. No longer can you consume in excess because your money is now worthless.

So if you now want to spend more, you’ll either need to earn or borrow more money. At this point, spending starts to decrease, as prices have risen in excess of what people can afford. Increased spending, over a long period of time, will inevitably decrease bond yields (interest rates).

And thus monetary policy cannot interest rates for a long period of time.

The second point that Friedman made is that monetary policy cannot peg the rate of unemployment.

At the time of writing his paper, Friedman acknowledges that this idea went against the grain, as it was, and still is, commonly viewed that monetary growth will simulate employment. And it’s true; however, not over the long term.

The reason for this is similar to that of interest rates. There’s a difference between immediate and delayed consequences of monetary policy. A lower level of unemployment will indicate an excess demand of labour. This will, of course, put upwards pressure on real wage rates. Meanwhile, a higher level of unemployment will indicate the opposite.

Now let’s assume central bankers want to peg unemployment. As an example, let’s say central bankers want to target an unemployment rate of 3%. If unemployment is higher than 3%, then interest rates will be lowered.

As we already know, lowering interest rates will stimulate spending, and income will start to rise. At the beginning, most of the income growth will take the form of an increase in output and employment. But, as more people are employed and output increases, prices start to rise. And as prices rise, real wages decrease.

Workers then start to negotiate wages, and the cost of production tends to increase. After a while, there is an excess supply in labour. Businesses start to hire less, even cutting back on their existing workforces. This inevitably increases the unemployment rate above the targeted 3%.  Central bankers are then left with the same problem on their hands.

While Friedman does explore this in his paper, it’s important to know what monetary policy can’t do.  Once we know, we can now assess whether cutting or hiking rates is the right course of action.

Last week, Reserve Bank of Australia made the decision to cut the cash rate from 2.00%, to a record low 1.75%.

The catalyst for the cut was inflationary date which came out 27 April, a week prior. For the first quarter of 2016, inflation was at -0.2%. This was the first time since Q4 2008 that inflationary data actually decreased, as shown in the graph below.

Forex Factory Interest Rates

Source: Forex Factory

As a result of recent inflationary figures, cutting rates wasn’t a major surprise. It seemed like the RBA had more reasons to cut than they had reasons to hold. However, some believe it was the wrong course of action.

Bernie Fraser, former RBA governor, criticised last week’s surprise cut. He warned that more monetary policy stimulus wouldn’t boost growth or reinvigorate inflation. Mr Fraser said the economic focus should instead be on government-led stimulus.

Fraser isn’t alone in his opinions. Many market commentators are criticising RBA and other central bankers in their race to zero or even negative interest rate. And, as I outlined before, according to Friedman, pegging interest rates is futile. It will only lead to eventual increases in the interest rate.

But what monetary policy can do is provide a stable background for the economy. Whether this is what the RBA is providing Australia remains to be seen. But there are many commentators predicting it won’t work. Instead, they believe we are all in for a much needed correction.

Härje Ronngard,

Junior Analyst, Money Morning

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