Central Banks Explain Radical Policy Shifts: First Australia

November 12, 2008

The Reserve Bank of Australia was hesitant about easing monetary policy with inflation still cresting. That central bank made its final two hikes during 1Q08 of a multi-year, 300-basis point tightening, and the resulting 7.25% cash rate was maintained for a half-year, as officials warned that a rising terms of trade and fiscal package would continue to support economic growth and keep capacity usage fairly tight. The first rate reduction in September 2008 was a timid 25-bp cut and came just one week before the chain reaction set off by the allowed failure of Lehman Brothers. After that seminal event, officials couldn’t cut rates fast enough, reducing them by 100 basis points in October and a further 75 basis points to 5.25% earlier this month. The RBA released its quarterly Statement on Monetary Policy on Monday, justifying the deep rate cuts and implying that more ease will be soon on its way. Another 75 basis points next month does not seem unreasonable given the still-elevated 5.25% benchmark rate level. The Monetary Statement describes severely stressed world financial markets since mid-September, including “a serious tightening in credit availability” and insufficient capital in the banking system. Heroic policy efforts have yielded some credit market improvement, but “sentiment remains fragile,” the statement asserts. The statement further observes deterioration in international and Australian economic conditions even before September’s shock and predicts that world growth will deteriorate more rapidly from 4Q08 onward. In Australia, consumption will be hit the hardest, aggravated by the drag on incomes of falling commodity prices, but investment, housing, and exports will also suffer. Moderating demand and activity, which are set to expand more slowly than “trend for some time,” already have softened labor markets. Employment growth has slowed, and job vacancies are dropping.  So is capacity usage. Along with the impact of falling commodity costs, the stage for a reduction of inflation to target is set, but it will take some time.” In sum, “renewed financial turmoil which began in the second week of September materially altered the balance of risks and raised the prospect that global economic conditions could be significantly weaker than previously assumed… {and lead to} greater downward pressure on inflation over time.” Projected Australian growth next year was revised downward significantly for the second time in two weeks, this time to 1.75%. GDP is expected to expand 1.5% in 2008. All such made “a significantly more rapid adjustment of monetary policy” necessary.

The logic of the Reserve Bank’s conversion to aggressive easing flows inevitably through the three-page Statement Overview. I’m only left wondering, as I have in the case of other policymakers, who appear to have been caught off guard, why this scenario had not been factored into policy-thinking sooner. Looking back, it’s hard to imagine how huge imbalances in savings and investment and associated wide current account disparities were going to be resolved in a soft-landing sort of way. The same puzzlement applies to how a massive buildup in household, corporate, and public-sector debt and housing bubbles in many economies. How likely was it that so many deep-seated economic and financial problems could have been unwound painlessly especially as they kept festering after credit markets malfunctioned fifteen months ago. Sooner or later, it all had to implode. The retirement of the baby boomers, the first of which reach age 65 in 2011, had loomed as one flash-point. That event, when many people shift from wealth accumulation to wealth spending, appears likely to dampen the prospects for restoring trend growth.

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