The consensus position of the last two years is that Australia’s interest rates will next turn upwards, having bottomed at their current 1.75%. But the alternative view, one gaining some favour, is that rather than fuelling inflation – a serious concern of course – lower interest rates are appropriate. This is because the old economic dynamics that allow the prediction of future inflation by the unemployment rate, appear to be dismantled in the modern economy.
UNSW Economics Professor, Richard Holden, writing in The Conversation, suggests that the evidence and the commentators are mounting evidence that the predictive guidance provided by unemployment rates no longer works – if it ever did. Just because it is the orthodox tool of macro-economic modellers, doesn’t mean it works!
Certainly, the expectation that there is a stable relationship between inflation and unemployment is widely, but not universally, held to be under pressure, as a result of modern dynamics that are disrupting labour markets. More importantly, at a broader and economy-wide level, this ‘secular stagnation’ (see * below for a bit more on this important topic) might mean that no matter what happens with unemployment, other factors are weighing across inflation rates and therefore interest rate policy.
Professor Holden points, as do others, to falling unemployment rates – currently 5.5% in Australia – but associated with stagnant wages growth as an example. We may opine all we like about the causes of this modern phenomenon, but regardless of the cause, it is a fact that is uncommon enough to disrupt the alleged historical relationship between unemployment and inflation.
Statistics Count has previously demonstrated that lower interest rates have also been of less utility than was once the case. With interest rates like those on offer now, business investment should be booming. But in general, it is not and in many sectors it is going backwards, at least relative to the already anemic economic growth rate.
Again, we can have all the discussions you like about why this is so, but around the Reserve Bank of Australia’s board table each month, the discussion will quickly be focused on what to do about the problem.
And it is a significant problem, because lower interest rates are not working to fuel investment and inflation even modestly. So, this is another disconnect that suggests the old correlations and relationships may no longer apply.
If that is the case, neither falling unemployment rates or low interest rates and benign inflation are doing their normal job.
Professor Holden describes as ’terrific’ and quotes widely, recent analysis and commentary by the former US Treasury Secretary Chairman Larry Summers, which came as the US lifted its interest rates for the third time to a range of 1% to 1.25%.
Summers comments, with words that Holden clearly feels have as much relevance for Australia as for the US, that:
“And I am confident that if the Fed errs and tips the economy into recession the consequences will be very serious given that the zero lower bound on interest rates or perhaps a slightly negative rate will not allow the normal countercyclical response.”
By this, Summers means that there is effectively no policy lever left to prime the pump on the economy (by lowering interest rates). As we have demonstrated above, in Australia at least, it doesn’t seem to work anymore. Providing some attribution, Summers goes on to say:
“Maybe the combination of a fire hose of global savings chasing too few productive investment opportunities has changed what level of interest rate can provide a serious boost to economic activity.”
So, interest rate rises could easily cause the US economy – and the Australian also, as Holden points out – to move into recession.
If the old lever of interest rates is not working any more, what exactly is the modern central banker to do? Increase rates and risk a recession for which you may have no answers, or reduce rates and risk really overheating asset prices, especially for housing?
Not an easy job being a central bank governor right now.
* Secular stagnation ~ is the condition of little economic growth in a market-based economy. It differs from cyclical and short-term conditions, suggesting that economic growth is operating under altered dynamics that cannot be resolved using traditional measures, requiring time to pass sufficient for conditions to resolve themselves.
