Why 1pc won’t do it

The RBA cut official interest rates for the second consecutive month last week. The objective is to reduce excess capacity in the labour market and generate inflation. Sadly, for the same reasons it hasn’t worked elsewhere, the RBA will fall short of achieving this objective. The Bank knows this is why Phil Lowe has been so vocal in calling on the government to step up to the fiscal plate and lend a hand.

Shifting priorities

To the outside observer you could be forgiven for thinking that since the global financial crisis, the objective of central banks has changed. Previously, the goal was to lower interest rates to pull the economy out of recession. Today, central banks primary purpose is to extend the cycle.

There is a good reason for this apparent shift. Central banks threw everything they had at the economy and financial markets following the financial crisis. Interest rates were cut dramatically and their balance sheets were expanded more than at any other time in history as the monetary authorities entered the market to buy up financial assets such as bonds and in some cases equities.

The intention was to raise asset prices, create a wealth effect that would then spill over into the real economy via higher consumption spending, production, business investment and employment. Higher wages would result and inflation would rise. Unfortunately, things didn’t work out that way. Instead, what we were left with is record amounts of debt.

The economy is now more sensitive than ever to even the slightest increase in interest rates. For this reason, central banks are keen to avoid a recession altogether and sustain the cycle.

When the cure is worse than the disease

Sustaining the cycle, however, with easy monetary policy alone is making it harder to generate the inflation we need to escape lower growth and lower interest rates. This is evidenced by the data. Despite record low interest rates around the world and central banks injecting record amounts into financial markets, inflation has remained stubbornly low and is falling in some cases (chart). 

Source: Bloomberg

There are a number of reasons that help explain why this is the case, such as new technology and ageing populations. A more general explanation, one that is tied more directly to the low inflation experience of most advanced economies, is that income and wealth inequality has increased.

Asset prices did indeed rise as a result of the post-crisis monetary stimulus, but it didn’t create the wealth effect that was intended. This is principally because not everyone owns the assets whose price was increasing. The effect was to widen the gap between high and low income groups.

This is significant because the spending patterns of low income groups have a greater effect on the economy than higher income groups. Standard multipliers established by Moody’s Analytics tell us that for every dollar received by low income groups $1.21 is added to the national economy. The same dollar received by high income groups adds just $0.39.

Size and speed

Inflation is not just a function of money supply. Pumping $14 trillion into the global financial system without generating inflation proves that. Inflation is also a function of how fast money passes through the economy (transactions). This is known as the velocity of money. Historically, the velocity of money was thought to be constant.

Quantitative easing and its effect in lifting inequality has seen that assumption shattered. As the chart below shows, the velocity of money in the US fell sharply after the financial crisis. This was also the case in Australia, Europe, Japan and most other advanced economies.

Source: Federal Reserve Bank of St Louis

The higher multiplier effect attached to low income groups means velocity is higher at the bottom than at the top of the income scale. So when income and wealth inequality rises, the velocity of money falls, weighing on inflation.

Think smarter, not lower

RBA Governor Phil Lowe has taken over where former Governor Glenn Stevens left off – urging the government to step in and help address the issue of low growth and low inflation.

The OECD in 2014 said government policies that help to limit or reverse inequality may not only make societies less unfair, but also wealthier. Both the IMF and the OECD believe the best way of redressing inequality is to lift the incomes of the low to middle income groups.

The recently passed tax package in Australia worth $158 billion over 10 years is a significant step in the right direction. Stage one offers a tax rebate payable as a lump sum each year for the next four years and is worth $15 billion. In 2022 stage one ends and stage two kicks in by adjusting the threshold for the 37 percent tax bracket up from $90,000 to $120,000, adjusting the top threshold for the 19 percent tax bracket from $37,000 to $41,000, and increases the low-income tax offset. This stage is worth $48 billion. Stage three is more focused on high income groups but doesn’t kick in until 2024.

Of course there are other alternatives available to the government including taking a more hands-on approach to wage setting. Despite having a precedent for it such a suggestion is likely to be seen as too extreme. Consider the alternative. Negative interest rates; a central bank that owns more than 50 percent of the government bond market or being the single largest owner of the equity market as is the case in Japan. Is it any more extreme than the idea of Modern Monetary Theory – where governments just print money and use it to sustain growth in the economy?

Easy money won’t work to lift inflation but that won’t stop central banks trying in the absence of any other alternative. For now, until governments realise what needs to be done, what easy money will do is increase asset prices at the expense of more sustainable growth in the future.