Reserve chooses wisdom over the chatter of economists

THE Reserve Bank board made a wise choice yesterday. And by doing so, it reminded us that its nine members set interest rates, not the bank's senior officials.

A year ago the board raised rates for the first time in this cycle despite market economists tipping no rise and News Limited columnist Terry McCrann saying it was "all but certain" rates would stay on hold.

This time the board left rates on hold despite economists tipping a rise, and McCrann telling us a rise was "all but certain".

The board did its job. On one hand, it would have heard the bank's senior officials argue that rates must rise to head off inflationary pressures they foresee if the resources boom develops as fast as they expect.

They may well be right, at some point. But the board also sees the data suggesting six interest rate rises in the past year have had a heavier impact than the bank had expected. Housing approvals have plunged, retail sales are lukewarm, as is business and consumer confidence.

The board knows that confidence in global financial markets is fragile and that inflation in Australia is falling, not rising. Why move now?

A rate rise yesterday could not have been based on what economic data is telling us, but only on what Reserve staff think is around the corner. The board was right to ask for more evidence before moving.

It meets next on Melbourne Cup Day six days after the release of September quarter inflation figures. If they show underlying inflation in check, a rise would be a hard sell.

The last meeting this year is on December 7, after the national accounts figures are released. That could be a good time to reassess the risks, when there is more data on how we're travelling, and maybe clearer signals on the world economy. .

Glenn Stevens's statement yesterday warns: "If economic conditions evolve as the board currently expects, it is likely that higher interest rates will be required, at some point."

That's true. What we don't know is whether conditions will evolve as the bank expects.

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Treasury backflip: Deficit no impact on rates

A TREASURY paper has endorsed the federal government's stance that Australia's debt and deficits have no significant impact on interest rates either short-term or long-term.

In a stunning backflip from Treasury's earlier views, a new paper by two economists finds no causal link between movements in Australia's budget balance or government debt levels and the margin between Australian and US interest rates.

An earlier Treasury paper was quoted by the opposition during the election campaign to support its argument that the government's deficits were responsible for the Reserve Bank's six interest rate hikes in the past year.

But incongruously, the new paper concludes that the variables that really decide Australia's interest rates are all born in the USA.

It found not only are US Treasuries the global benchmark for interest rates, but the margin between them and Australian rates is determined primarily by shifts in US core inflation and the US current account deficit.

"All else equal, the results suggest that, in the long run, the real interest margin rises by around 3 basis points in response to a 1 percentage point (100 basis points) of GDP increase in the stock of Australian general government net debt", the paper reports.

The margin also rises by 10 basis points if the US government net debt falls by a percentage point something that, at this point, appears unlikely to happen any time soon.

"In the short run, Australian fiscal variables do not have a statistically significant impact on the interest margin," it concludes.

The paper, by Yong Hong Yan and Shane Brittle from Treasury's macroeconomic group, carries the usual disclaimer that its views are not necessarily those of Treasury. But they do match those of Treasury secretary Ken Henry, who has consistently played down any link between the budget deficits and rising interest rates.

Reserve Bank governor Glenn Stevens has also played down any link, arguing that it is the trends developing in the economy that influence setting short-term interest rates, and fiscal policy changes are rarely big enough to have an impact.

But the Treasury paper challenges a large body of work by other economists that find a strong link between fiscal policy and interest rates. A review published last year by the OECD suggested a strong, if highly variable, relationship, with long-term rates forecast to rise by between 10 and 60 basis points if the budget balance declines by 1 per cent of GDP.

Treasury Working Paper 2010-04: Reconsidering The Link Between Fiscal Policy And Interest Rates In Australia, Friday, 17 September 2010

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