A relatively modern discovery of the branch of economics called macroeconomics is the empirical relationship between the rate of inflation and the rate of unemployment. The relationship, which was discovered in 1958 by UK economist A.W. Phillips, shows an inverse relationship between the level of unemployment and the rate of change in wages. We have reinterpreted it since then to show an inverse relationship between the unemployment rate and inflation.
It has been the subject of a long debate among economists and took a hit during the 70s when high inflation rates occurred along with high unemployment rates around the world. Economists have thrown themselves into the crucible of debate on whether there is a fundamental underpinning to this relationship that can hold theoretically. This is part of the reason they have consigned themselves to the margin of debate on economic matters.
This relationship describing a competing set of forces that need to be balanced when setting macroeconomic policy has been an excellent guide for generations of policy makers for setting monetary policy and, to a lesser extent, fiscal policy. For the non-economist readers among you, monetary policy broadly relates to the setting of interest rates and fiscal policy broadly relates the size of government expenditure and taxation revenue.
What they taught us very early in our economic degrees was that when you have two policy aims, such as price stability and full employment, you needed to policy levers or instruments, such as monetary policy and fiscal policy.
If you only had one policy lever, there would inevitably come a time when the policy aims would come into conflict with each other.
What would happen if you only had monetary policy to work with and high inflation required an increase in interest rates and high unemployment required a decrease in interest rates?
We are on the track to finding out since the changes to the charter of the Reserve Bank, which has had the maintenance of full employment, added to the maintenance of price stability as dual responsibilities.
In Australia, we have an inflation rate of 7% and an unemployment rate of or 3.5%. The unemployment rate has been stuck resiliently at a low level at the embarrassment of economists who expected it to rise with interest rates. https://www.abc.net.au/listen/programs/worldtoday/resilient-jobs-market-stokes-rate-rise-risk/102219402
This is a classic set of circumstances that cries out for higher interest rates, which is exactly what they delivered to us in the May meeting of the Reserve Bank board.
Australia’s last recession was in 1991 and the unemployment rate was significantly higher that it is now. The inflation rate was at a similar level to what it is now, although interest rates rose to restore price stability and caused the unemployment rate to climb to 11%. The interest rate on home loans went to 17% but the interest rate lever worked. High levels of price inflation did not appear again for 30 years.
Maintaining the inflation rate in a range of 2 – 3% is a target agreed between the Howard government and the Reserve Bank nearly 3 decades ago and has been the primary goal of the monetary policy for all that time. The mystery is why the decision to increase interest rates after the May meeting of the Reserve Bank board was such a surprise to market participants. Witness this article on the ABC https://www.abc.net.au/news/2023-05-02/rba-interest-rate-rise-may-2023/102292616
The question that exercises our minds now if we are in the business of predicting future interest rate is what next? Has the interest rate cycle peaked or is there more to come?
To figure this out correctly requires two things. The first is luck, the second is to stand back from the minutiae of data and look at the forest rather than the trees.
Since the first requirement is out of our hands, let’s go to the second requirement. Whereas the Reserve Bank used to have access to information and analysis that economists in the private sector couldn’t match, it has now fallen into the same class as wannabes that economists outside the Reserve Bank occupy.
It has even entered the world of punditry in forecasting interest rates up to two years hence. Anyone who understands about the random walk that economic and especially financial variable take will recognise this to be a mug’s game.
It came horribly unstuck when the Governor suggested 2022 that interest rate would remain essentially unmoved until 2024. Whereas they used to fly with the eagles, they have come down to the level of the turkeys. We are all now forced to make the best decision for the day according to the most recent data and our best analysis and let next month’s decision rest on fresh data and analysis.
A second and more subtle shift has occurred. Asset price inflation intruded into the reckoning of consumer price inflation as part of the assessment of where interest rates should go. When I say asset prices, I really mean house prices. House prices are rebounding after a smaller than expected drop given the nearly a year’s worth of interest rate rises. https://www.abc.net.au/news/2023-04-30/corelogic-house-prices-rebound-interest-rates-housing-market/102284450
This is a justifiable addition to the inputs to consider when determining what to do with monetary policy since just as high levels of inflation have harmful effects on the functioning of an economy, so do spiralling asset prices. Interest rates have a clear role to play in curtailing them.
So we have a stubbornly low unemployment rate, an inflation rate more than double the desired range and asset prices on the rise. Add to this the historical evidence on how painful it is to remove inflation from an economy and I can’t see the May interest rate rise being the last one in the current cycle.
It is important for the long run health of the economy that they prosecute this battle to reduce inflation, but now we have a central bank that has the job of maintaining full employment on top of price stability.
Where is the clarity of thinking?
There is a long and interesting backstory to this difficulty, but that is for another time.
