When the RBA Raises Rates to Stimulate the Economy

When the RBA Raises Rates to Stimulate the Economy

The Reserve Bank of Australia featured heavily in the financial news this week. In Australia mostly, but also for a morning here in the UK too.

Anticipated interest rate cuts made Aussie government bonds rally — and Strategic Intelligence subscribers were positioned to profit.

And the Aussie dollar fell, driving up the Aussie dollar gold price. Strategic Intelligence subscribers were, once again, positioned to profit.

Rate cuts are supposed to help the economy along. By making people borrow more, or by making their existing debt cheaper. This Daily Reckoning challenges that assumption. Because it ain’t true. Not anymore.

Central bankers see themselves as driving the economy. Keeping it from going off the rails to either side — deflation and inflation.

But what if they’re actually like the little child in the back seat of a car, playing with a plastic steering wheel connected to nothing?

This sounds odd, but Deutsche Bank analyst Torsten Sløk claims his charts suggest it’s the case. They show no economic response to recent monetary policy changes in the US. The Federal Reserve has been turning the wheel, but nothing actually happened to the economy. The same for Japan over the last few decades.

If monetary policy hasn’t worked, then it must not work, because we’ve tried it. Simple.

That’s just one explanation for why monetary policy is flailing and failing so badly. In today’s Daily Reckoning, we dig into a few more.

But as we go along, don’t forget it’s unlikely that the extraordinary actions taken by central bankers do nothing at all. The real question is what they do, do.

Why are central bankers having such a miserable time?

There are plenty of explanations…

The economy’s inflation and deflation rate naturally changes. Which means the central bank could be offsetting adjustments that need to happen for the economy to stay stable.

If a deflationary shock is what allows the economy to grow again in the aftermath of a crash, then removing that deflationary shock leads to the weak economic recovery the world had from 2008. And Japan had from 1990.

Here’s the US data from The Market Ear showing how badly the economy has underperformed in the ‘recovery’:

Source: The Market Ear

The view that recessions are needed is considered masochistic by modern economists, because it’s not very pleasant. And because it puts most economists out of job by making their policy fixes for recessions look ill-advised. But there’s plenty of evidence it is correct and the theory is sound.

That theory suggests a recession is a period of cleaning up past mistakes — investments that did not make sense. A reallocation of capital.

The CD factory becomes an iPhone screen protector factory. The recession is the period of transition during which output, employment, and prices all fall. The point being that it’s necessary and good in the end.

But if you prevent the readjustment with bailouts and cheaper debt, you end up with economic doldrums, like those much of the world is in. And that’s just what central bankers are doing by keeping failed companies afloat with 0% financing.

The CD factory survives, but only sort of.

On to another way to understand the misguided nature of central banking. This one focuses on how they’re looking at the wrong numbers when they make their decisions. As are you when you read about the RBA’s claims this week.

Here’s how things are supposed to work. Without central banks, the interest rate would be determined by the free market. The supply and demand for saving and lending money. Central bankers merely influence diversions from this rate.

Which means raising or lowering the interest rates tells you nothing in and of itself. The real question is how much higher or lower the interest rate would be in a free market. That tells you the effect of central bank policy.

So, what is the current effect of central bank policy in Australia?

It’s hard to tell, right? Because what level would interest rates be at without central bank policy? We don’t know. And neither do central bankers.

Perhaps interest rates would be much higher, but the central bank is pushing them down. But that’s indistinguishable from the opposite situation.

Lower interest rates don’t stimulate the economy if they should’ve fallen much more in a free market.

The result is that central bank policy making is clueless because it has no reference point. What should interest rates be, and what is the central bank actually doing by imposing its policy? Nobody knows.

It’s not just that central bankers are clueless. The transmission mechanism they use to impact the economy broke just when central banks needed it.

Central bankers control interest rates. Which means their tool for fiddling with the economy works via debt and borrowing. But if people aren’t really interested in borrowing at the moment, then fiddling with interest rates has less impact.

Demographics tie into this story nicely. People nearing retirement don’t want to borrow, they want to save. And those savings are negatively impacted by interest rate cuts. And positively impacted by interest rate hikes. That’s the opposite of how debt and borrowing are impacted.

Thanks to the demographic shape of the Western world, the central bankers used to have a lot of clout. Because baby boomers were busy borrowing and in debt. Interest rates impacted baby boomer budgets and borrowing significantly.

But now they’re more interested in savings and pensions, which interest rates have the opposite impact on. Low interest rates reduce savers’ income. High rates increase their income.

Based on this, here’s a weird prediction for you. In a few years’ time, the RBA will raise interest rates to stimulate the economy and they’ll lower rates to curb spending. The focus will be on the return to savers and pension funds, not potential borrowing.

Japan is close to that point already. And in Europe, the European Central Bank has admitted its low interest rates are the cause of financial instability and pension busts. Returns instead of debt matter more and more.

But Australia isn’t far behind. In the meantime, during the transition of monetary policy theory from focusing on debt to focusing on savings, fiddling with interest rates doesn’t do much of anything. The two interest groups cancel each other out.

For every dollar of benefit to a borrower from low interest rates, a saver is missing out on income. The net effect is what you see in the news. Not much economic benefit to policy changes — Torsten Sløk’s discovery.

If all that sounds bizarre, find a Japanese person and ask them about it.

Or a European banker who is supposed to be stimulating the economy by lending out his money at negative interest rates…

Or a Modern Monetary Theory believer. They see interest rates as a handout to the wealthy. It’s just free returns for having capital. Higher interest rates cause higher inflation because it’s a handout to the rich.

That’s the end of today’s tour of central bank failures. I hope you can see what they’re getting so badly wrong. They can’t…

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia