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The minutes of the monetary policy meeting on October 3 of the Reserve Bank Board were issued last week. They cause a stir. The Board decided to leave the cash-rate target unchanged at 4.1 per cent. That didn’t cause the stir. Several observations and the concluding comment did. Here are some pertinent verbatim extracts from the minutes, including the concluding comment:
♦ Members noted that inflation remained well above target and was expected to do so for some time [and] acknowledged that upside risks were a significant concern given how long inflation is likely to remain above target.
♦ Services price inflation remained sticky [and] fuel prices were adding to headline inflation [and] could influence households’ inflation expectations.
♦ Members noted that core services inflation remained persistent internationally.
♦ In reaching their decision, members noted that some further tightening of policy may be required should inflation prove more persistent than expected. The Board has a low tolerance for a slower return of inflation to target than currently expected. Whether or not a further increase in interest rates is required would, therefore, depend on the incoming data and how these alter the economic outlook and the evolving assessment of risks. Members reaffirmed their determination to return inflation to target within a reasonable timeframe and their willingness to do what is necessary to achieve that outcome.
Numbers of economists highlighted the more “hawkish” tone of the minutes compared with the previous month’s. No doubt this will be reflected in the odds of a further rise in rates when the RBA board next meets on November 7. Personally, I don’t think we will see such a rise; then I’m not in the heads of the RBA board members. In other words, as Manuel from Fawlty Towers put it, I know nothing — except that I know what I think. And I don’t think rates should be raised again in November or in December.
A tightening of monetary policy takes considerable time to work to reduce inflation; as long as 12 to 18 months. Since the start of May 2022, the cash rate has been increased by 4 points to 4.1 percent; the last rise of 0.25 percentage points in June 2023, only four months ago. The effects of the tightening are only in an early stage. Has enough tightening already been done? That is the question.
For comparison purposes, during the Howard years March 1996 to December 2007, the cash rate averaged 5.5 percent (rounded up). On that basis, the prevailing cash rate appears to be underdone. But let’s not forget that times were good under Howard and Costello. Businesses and individuals were better placed to afford higher interest rates. It’s also true that the ability of the economy to adjust to higher rates is not invariant to the pace of change. An increase of 4 percentage points over 18 months takes some digesting. To wit, many business and individual projects made on the margin might survive modest and measured increases in interest rates. Rapid and substantial increases in rates are another matter. Finally, to the money supply.
The money supply is the principal (foundational) variable when mounting a fight against inflation. But search as you might, you will find no mention of it in the RBA board minutes and no mention of it in the press when market economists were holding forth or being quoted. I could have missed something obviously.
Inflation is a persistent and appreciable rise in the general level of prices. It’s counterpart is a persistent and appreciable fall in the value of money. And, as with any normal good, the more money supplied the lower will be its value. Ignore that as an economist and please de-credential yourself, forthwith.
So, what has the money supply been doing over the last year. The latest numbers available from the RBA are to the end of August. I’ll use two measures. The first is transaction deposits held with ADI’s (banks and other deposit-taking institutions). They have declined by 2.6 percent over the year. Hold the headlines! That shows that tightening may already have gone too far. However M3, which includes cash holdings plus the aforementioned deposits plus other deposits with ADIs, has increased by 4.3 percent over the year. Still, it is important to understand that this represents a real decline in the money supply. It is growing less than are prices. It is on a deflationary path.
My modest proposal is that the RBA takes account of the money supply when setting interest rates. Let me finally add, rising fuel prices caused by external events are in themselves deflationary not inflationary. In isolation they lower the real money supply. It’s a common error. The effects of supply and demand driving up specific prices is confused with inflation. Specific price rises only become inflationary when their flow-on effects are accommodated by increases in the money supply. The chances of this happening with interest rates at their current level and in the current economic circumstances are minimal. Too esoteric? Well then, how sensible does it sound to increase interest rates in response to an impoverishing increase in international fuel prices? Right, not sensible at all. You got it. Hopefully, so has the RBA.
I confess to not understanding the premise of interest rate increases to limit price inflation. In the first place, price inflation is self regulating in that it should not only (temporarily) increase supply but also (temporarily) limit demand.
Raising interest rates not only increases supply costs (increasing inflation), it also results in more money creation, which also increases inflation. So I wonder if it only makes it worse, or at least more painful than necessary. Mortgage interest rates are pretty much irrelevant to my spending patterns right now – what matters are groceries, insurance, fees, fuel and energy. The additional interest rate is just another thorn which would otherwise be partially offset by savings interest except that the tax commissioner takes all of that, conveniently mistaking the spelling of ‘interest’ for ‘income’.
As you succinctly put it Peter, ‘The effects of supply and demand driving up specific prices is confused with inflation. Specific price rises only become inflationary when their flow-on effects are accommodated by increases in the money supply.’ This is covid policy in a nutshell. Supply squashed, money supply on steroids.
In my world of limited economic knowledge interest rates should be market driven rather than bureaucratised. How is this any different to ‘managing’ the international exchange rate? I would have thought that money supply is also then a derivative of the market (borrowing), and government debt. The reserve bank should be a clearing house and interest rates should be decided by commercial banks. Or perhaps we need some real measure, like a gold standard.
Peter might correct me on this, but I think the role of interest rates is that they are the mechanism by which the RBA withdraws money from the system. If the RBA puts up the interest rate that it pays the banks for deposits at the RBA, then the banks will transfer money to the RBA until there is a balance between borrowers and savers at the new rate. The RBA can also use “quantative tightening” by selling government bonds they hold into the market. That withdraws money from the system when buyers pay for the bonds, and pushes up interest rates because borrowers now have to compete with those “risk free” bonds.
So the goal when fighting inflation is to reduce the money supply. The secondary effect of that reduction is higher interest rates. Keynesians concentrate on the interest rates. Monetarists who follow Milton Friedman concentrate on the money supply. I follow Friedman. Nearly all modern economists are Keynesians cultists.
Thanks Carl, that makes sense.
Consume less- fixed.
Thanks Peter.
I don’t believe any of it!
What is ‘money’?
Where does it come from?
What is the basic cause of Inflation?
These questions must be answered!
Who remembers the Halfpenny or the Penny?
They are long gone!
The next ‘trick’ was decimal currency!
Now the 1 cent and 2 cent coins have been withdrawn from use and the 5 cent coin is worthless unless you require counters in a game.
You see, the ‘value’ of our money has been debauched over many years. Inflation, regardless of rate, is compounding year after year.
The Reserve Bank Board has failed in its Charter to preserve the value of the Nation’s Money.
Don’t blame the RBA Board because this policy is sanctioned by the PEOPLE WE ELECT!
It appears the fundamental policy of ‘the controllers of Finance’ is to see that as few as possible of the Australian People, become financially independent.
They do it with Inflation, taxes, and mystique behind a veil of lies.
Louis Cook : “What is ‘money’?” A good question.
Answer: Money is what money does…..
Consider, for example, the first years of settlement in New England. The wampum or shells used by Indian tribes became accepted as small coinage. In 1641 in Massachusetts, it became legal tender, but subject to size limits on transactions at six shells to the penny. The worth of wampum depended on its redemption by the Indians for beaver pelts. The Indians were, according to John Kenneth Galbraith …”in effect, the central bankers for the wampum monetary system and beaver pelts were the reserve currency into which wampum could be converted. this convertibility sustained the purchasing power of the shells.”
When pelts ceased to be available as settlement expanded, wampum ceased to be convertible, lost its purchasing power and disappeared from circulation except as small change.
A question for today’s central bankers, then, is how to maintain the purchasing power of our shells (notes) now that there is no obligation, as David Riccardo suggested in 1817, “subjecting the issuers of paper money to the obligation of paying their notes either in gold coins or bullion.’
If paper money is/was one of the great mysteries of modern economic life, today it’s “digital currency” and of course bitcoin. The latter just broke through USD30,000, yet gold remains under USD2,000 an ounce.