Don’t Blame the RBA

You could never accuse those who wrote the legislation to establish the RBA in 1959 of lacking lofty ambitions.

The RBA’s three key, oft-repeated tenets — ‘to contribute to the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people’ — cover just about everything economic you could expect a government to do. It’s actually hard to think of something beyond this broad scope.

What often gets lost, however, is that one key word — contribute. I’m sure those who wrote the Reserve Bank Act never envisaged a day where the RBA would be responsible for everything.

But that’s the way it has gone for the last decade. As the political malaise has set in, the punters have given up on any hope of a properly functioning government.

Does anyone really think either side of politics will balance the federal budget anytime in the next decade? I don’t. Each side blocks the other when in government, so the debt just balloons while they blame each other.

How could the budget run at a surplus, when the success of a policy is now determined by how much the government spends on it? The only way to cut through the noise is to announce more spending than the other side.

It’s this quagmire that has promoted the role of the RBA well beyond its original scope. When it comes to the economy, the importance of the RBA governor’s role is now only topped by that of the federal treasurer. Although, there are plenty who’ll argue the toss on that.

Of course, it wasn’t always like this. There was a time when the RBA’s primary job was to print money. When those in the Department of Treasury saw it as a lowly offshoot.

Governments have numerous tools at their disposal. They can decide how they want to tax and spend. By introducing and adjusting subsidies and levies, they can divert the flow of investment funds into projects they want to implement.

All the while, the RBA only has one tool at their disposal, and it’s the bluntest tool in the box — interest rates. It’s the job of the RBA to set the rate at a level that it believes has the best chance of ticking the three boxes listed above.

If only the RBA really could run the economy with a single tool in its arsenal.

When prices of our key commodities like iron ore and coal collapsed, lower rates helped Australia avoid a recession. And after the massive capital pumped into the energy and resources boom dried up, low rates helped boost housing construction.

Given that housing construction is our biggest employer, this boon in new dwellings helped keep a lid on unemployment. After peaking at 6.25%, the unemployment rate fell to 5.5%. Compare that to the US, which peaked at 10% as the subprime disaster played out.

We often lament tepid wage growth, but it’s a moot point to those that don’t have a job. Low wage growth keeps a lid on consumption, but high unemployment is the biggest killer to an economy. Not to mention the breakdown in social cohesion that often comes with it.

Low rates have helped keep the economy out of recession, but there’s always another side to the equation. For those relying on their savings to generate income, each interest rate cut has taken another slice out of their income.

And for those who so desperately want to get into the property market, news of double-digit house price gains is yet more proof to them that they’re destined to miss out.

Central banks around the world have been pilloried for the amount of money they have ‘printed’ to keep their economies ticking along. However, whichever way you slice it, they’ve been cleaning up someone else’s mess.

The passage of time might tempt us to downplay the impact of the subprime fiasco. But a decade ago, the financial world was within a hair’s breadth of total collapse. It’s impossible to comprehend what the aftermath would have been had all the banks gone under.

And even if the banks had survived, if central banks had kept a ‘neutral’ stance on rates at the time, you could bet that unemployment would have peaked at much higher levels worldwide. As you can see in the chart below, after topping out at 10% in October 2009, in the US today, the unemployment rate is 4.4%.

US unemployment chart

Source: United States Department of Labor
[Click to open new window]

While the unemployment rate has steadily moved down, the Dow Jones has been for one of its biggest runs ever. After trading below 6500 in 2009, the Dow Jones has more than trebled, closing above 21600 overnight.

It’s impossible to argue that central banks always get it right. When the US economy ticked up in 2011, some economists argued for a rate rise. But with unemployment still hovering around 9%, it was too soon for the Fed to move.

And with the RBA, two successive rate increases of 0.25% in early 2008 up to 7.25% baffled me at the time. Particularly because our market had dropped around 1000 points in only a few months.

But the real test now for the Federal Reserve is whether they can lift rates without bringing the whole thing crashing down. Not just to get it to some theoretical rate for the sake of it, but also to give them some firepower should this bull run come to an end.

Depending on how you calculate it, bull runs on the Dow Jones average out to around seven years. This current run is now into its eighth year. If the Fed can raise rates without halting the bull run, it might just have pulled off the greatest Houdini act in history.

After the bounce in the Aussie dollar last week, the RBA was quick to talk the currency back down. The last thing it needs is for the dollar to rally, and with it lessen the demand for our export commodities.

The problem for the RBA, though, is that it’s trying to run the economy with a single lever at its disposal. It might be decades before we know if this low interest regime pays off. But low interest rates with low unemployment have to better for most than the other way round.

Like it or hate it, the RBA has done what it had to do. What chance now, perhaps ever, that a future government might once again have a crack at running the economy?

Kind regards,

Matt Hibbard,
For Money Morning

Money Morning Australia