Wednesday, August 03, 2016

Confusions over the economic outlook 1 interest rates

The Australian Reserve Bank has just cut the Australian official cash rate by .25 to 1.5%. I would have kept it on hold at this point, but that's just me. However, it does raise raise an issue. I must admit that I am very confused at the moment about the economic outlook. So in the next few posts I want to explore my confusions. Perhaps you can help me resolve them.

Let's start with interest rates. They are low at the present time, but in Australia at least depositors still receive a real rate of return. I suspect they do in Japan. So far as the banks are concerned, they too receive a real rate of return on loans, in the case of credit cards a very high rate of return. Where, then, is the problem? It can't be the level of interest rates as such.

The argument about low and lowering interest rates is normally put in terms of its affects on investment and consumption at a time when we want demand to increase when investment in particular is low. If we lower interest rates then, or so the argument runs, firms will borrow more for investment, consumers will borrow to spend, and the economy will grow.

I would have thought that there were a few tiny problems with this.

Take consumption first. The amount consumers spend out of income, the consumption function, has been analysed in various ways. To my mind, the consumption function is a combination of income and capital effects. If you income goes up, you will spend a little more. If your assets go up, you will turn some of that increase in value into consumption. In both cases, the effects depend upon your judgement about the long term sustainability of the change in income or asset values.

In the old days of just a decade or so ago, people expected their income to increase on a regular basis. A sensible, rational approach was to peg spend to the old salary and invest the increase in income, thus actually lowering the consumption function while improving family wealth. As your wealth rose, consumption would finally rise, if with a lag.Today, nobody is really sure of employment, while the effects of reducing interest rates on consumption are probably negative in that those who have more cash as a result are more than offset by savers who now have less cash.

Now look at investment. Investment decisions come back to the expected return. When times are poor, shifts at the margin in interest rates have very little influence given the range of other factors involved. Just lowering the official interest rate may but need not increase the profitability of existing investments, but really has little influence on new investment unless rates are very high or the interest rate reduction very significant.

I will continue this series Friday with the concept of the liquidity trap.


2 tanners said...

The theory looks even more shaky if the banks simply increase profitability by not passing n interest rate cuts (as they appear not to be doing). This then frees them to make higher profits or support riskier speculation (e.g. in houses or stocks), neither of which generate real income.

This isn't a 'bash the banks' comment, I just don't understand the reasoning.

Winton Bates said...

It seems that lowering the interest rate no longer has much effect on the exchange rate in Australia. I wonder what will happen if the whole world adopts exchange rate targeting as in Singapore. See:

Anonymous said...

Sometimes I think that a government which simply announced that there'd be absolutely no major policy changes enacted for 10 years - i.e. what you've got is your predictable business and personal environment for the next decade - would be doing us all a favour. Instead, we're stuck in the vowels:

avoidance of risk, exacerbated by
erratic political environment, leading to
insufficient confidence, and then there's
overregulation, all of which leads to
unwillingness to invest.


Winton Bates said...

kvd: That is a good point. Policy uncertainty looks to be a big factor behind the decline in investment in many high income countries over the last 15 years or so. It looks like we have low investment leading to low growth, increased job insecurity, the rise of xenophobia and hence greater policy instability.

However, I doubt whether we could have no policy change for ten years without a fiscal crisis. If no policy change Involved no increase in government spending in real terms it would actually be a major reform.

In terms of monetary policy, no policy change would involve sticking to the inflation targeting rules we currently have. However, the Reserve bank seems to have a problem in convincing people that it has the means and the determination to meet those targets.

Anonymous said...

Winton, I agree with your comments, except that instead of the publicised 'inflation target range' supposedly at the core of the RBA's activities, I'd make it a 'desired upper bound over the economic cycle' with no downside responsibility/action.

Seems to me that inflation really is a stealth tax (it advantages both government and borrowers; both being users, not providors, of capital), so why give any sort of encouragement for government action which would seek to promote it in the event it falls below 'target'?

And also re your comment on exchange rate target: would that not lead to artificiality, and hence vulnerability, in an economy as small as ours?


Winton Bates said...

kvd, I agree that the idea that any amount of inflation can be optimal seems peculiar. The way I rationalise it is that because of quality change issues, price indexes tend to overstate the rate of inflation. So, our target band might not be too far away from zero inflation. We also need to consider expectations. If people have come to accept 2% p.a. CPI increase is the norm, it will take many years to persuade them that they should expect the rate of CPI increase to be 0% p.a. in future.

It will be interesting to see how Singapore goes with its exchange rate targeting. If we went down that path my concern is that the import-competing and exporting industries would always be lobbying the government to lower the exchange rate target to improve their "competitiveness". If the whole world does it, we will be in a world of competitive devaluations. That might not end well.

Jasper Gnomes said...

Hi Jim - I tried to find out exactly what the Reserve Bank does apart from setting interest rates. So I looked up the Reserve Bank Act 1959 (superseded) and there seems to be only one reference to their (the Board's) actual duties, as in Part IV—Central banking sect 26 Reserve Bank to act as a central bank
The Reserve Bank:
(a) is the central bank of Australia;
(b) shall carry on business as a central bank; and
(c) subject to this Act and to the Banking Act 1959 shall not carry on business otherwise than as a central bank.

Yeah but what do they actually do? Most of the Act covers administrative stuff such as remuneration for Board members etc but doesn't actually say what they do from day to day. Geez I could set interest rates based on:
1. The toss of a coin
2. The opinions of economists
3. The current betting odds of a rate rise/cut
4. The Sydney Morning Herald

Section 26 (b) is pretty much open to whatever they want it to be.
A day in the life of Glenn Stevens - wobble head, look important, hold clipboard, buzz cut, wobble head, get someone to write reasons for latest rate cut, visit tailor and once a month sit around a table with other Board members and make a decision on interest rates.

A bit like the IOC. Nice work if you can get it.

Noric Dilanchian said...

I appreciate the discussion here, and Jim's article which inspired it. I'm out of my depth in trying to understand parts of it. It all deserves a few more readings.

Therefore, I'm only here sharing a link to a New York Times article confirming what has been known for some time: low growth data appears in the United States and other countries.

"We’re in a Low-Growth World. How Did We Get Here?"

Jim Belshaw said...

That's an interesting article, Noric, that Winton picked up in a comment on my next post.