Are all interest rate cuts created equal?

Are all interest rates created equal

Yes and No. All interest rate cuts (or rises) are the same IF they occur in the same circumstances – in other words either yes or no is far too simple an answer. A little (I promise a little) economic history.

In 1958 William Phillips produced “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”. By 1960 this work had been simplified and applied as the economic rule that there is a link between inflation and unemployment: when inflation was high, unemployment was low, and vice-versa.

All good. And then in the 1970s stagflation occurred. High inflation and high unemployment.

Milton Friedman famously described this situation as “too much money chasing too few goods”. In 1976, Friedman won the Prize in Economic Sciences in Memory of Alfred Nobel “for his achievements in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilization policy.”

80s 90s and early in to the 21st Century the consensus view, shaped by Friedman, was that inflation was the scourge of communities and the government needed to balance its own economic activity across the economic cycle to manage the inflation genie back into the bottle, and keep him there. “Balance across the cycle”.

australian cash rate history

During low economic growth the government spending encouraged activity and deficits could and should be run, and during times of strong economic growth the government should scale back its own spending and not compete with private sector activity – thus reducing inflationary pressures.

The Hawke/Keating government particularly did very well, at minimising wage inflation and supporting productive growth.

The Howard/Costello government included the longest period of sustained growth in Australian history.

Rudd/Swan, Gillard/Swan, Rudd/Bowen won’t be viewed as excellent reformers, or astute managers of the national economy. They have largely muddled through.

Historically (80s to early 21C) a lower spending government could legitimately claim that (all other things being equal – i.e. fantasy) that they would keep interest rates lower than the other option. What is really being claimed it is that the Reserve Bank would not need to raise interest rates to take heat out of the economy and reduce the (risk of) inflation increasing – BECAUSE the claimant would be overall less of a pull factor in the economic activity.

Our current circumstance is very different to that. Post GFC Australian consumers have become net savers, economic growth is not strong, the risk of inflation seems low. The RBA is lowering interest rates to try and encourage private sector economic activity.

Productivity growth is anaemic, and the inflationary outcomes across the Australian economy are quite varied. Tradeable goods (that which we can import and export) are low inflation, whereas non-tradeable goods (substantial costs to our exporting manufacturers) are relatively speaking higher inflation.

So is this a good or a bad interest rate reduction?

The reason is the economy is weak – bad.

Private borrowers (home loaners) will appreciate the reduction in cost – good.

Inflation pressures and expectations are low – good.

Cheap money risks bubbles – bad. (and it is now certainly historically cheap)

Productivity growth – needed.

Control in the increase in Fed Government spending – needed.

Providing a platform for private sector investment and growth – needed.

Fed revenue reform (Henry review or other) – needed.


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