- The Australian
- 12:00AM February 13, 2017
- DAVID UREN
Economics Editor
Canberra
The IMF has urged the Reserve Bank to slash rates in a much more pessimistic analysis of the outlook than presented in the bank’s latest forecast, arguing the economy is at risk of getting caught in a Japanese-style low inflation and low growth trap.
The fund presents extraordinary modelling showing the Reserve Bank should halve its policy rate over the next six months to 0.75 per cent, which it says is the effective “lower bound” for nominal rates in Australia.
“A prudent risk management strategy in the current situation would aim to avoid ‘dark corners’, where the economy could get stuck in a low inflation and low-growth trap. Put differently, a ‘low for longer’ strategy would be best suited to minimise those risks,” the IMF says in a staff paper prepared for the fund’s formal annual review of the Australian economy.
The IMF stance is in sharp contrast to the Reserve Bank’s Philip Lowe who declared last week that with the global economy picking up speed, “the days of further monetary easing are behind us, and that’s good”.
Lowe said his central forecast was for the Australian economy to sustain growth of about 3 per cent over the next few years, “which by the standards of other countries is pretty good”.
However, the fund says the Reserve Bank’s current cash rate is much less stimulatory than it appears, arguing that the “equilibrium interest rate” — the rate at which economic activity is neither being stimulated nor restrained — has halved from 2 percentage points above inflation to just 1 percentage point since the onset of the global financial crisis.
The fund says the persistence of Australia’s underperformance in the face of the Reserve Bank’s rate cuts is evidence of the fall in equilibrium interest rates. The IMF estimates that the economy’s production is falling short of its potential, with an output “gap” equivalent to 1.3 per cent of GDP.
Although the “equilibrium” interest rate cannot be measured directly, the IMF used three different modelling techniques to estimate it. “All three methods point to large drops in the real equilibrium interest rate (EIR) in Australia to levels near 1 per cent. This implies that monetary stimulus in the economy would be less than widely thought.”
The IMF says equilibrium interest rates have fallen around the world since the global financial crisis.
“For open economies with high capital mobility, such as Australia, the domestic rate will be strongly driven by global interest rates, that is, the EIRs in other major economies,” it says.
National differences would be due to country-specific factors such as a nation’s “risk premium”.
“In the Australian case, the country risk premium is likely to depend in part on its net foreign liabilities and related perceptions of repayment risks,” it said.
The result has been inflation falling persistently below the Reserve Bank’s target, with inflation measures for both tradeable and non-tradeable goods and services dropping below the target level for the first time ever.
“These facts highlight the new challenges that the current episodes pose for monetary policy in Australia,” the IMF said.
“Once low inflation becomes entrenched, it could be very difficult to correct, leading to economic costs that can be considerable, such as those incurred for example, in Japan and the euro area.”
“With an EIR of around 1 per cent, the RBA faces relatively greater risks of reaching the effective lower bound of about 1 per cent than it would if the EIR were higher.
“Hence, it could face a situation where there is little room for a monetary policy response to negative shocks with the conventional cash rate tool, and it will be important to explore the scope for unconventional measures.”
The IMF paper says an “optimal” monetary policy should make more effective use of “conventional policy instruments” (particularly rate cuts) and making better use of communication. It says the Reserve Bank should give clearer guidance about the future course of its cash rate.
It says the bank should stand ready to use “unconventional” measures, such as asset purchases, directly funding bank credit and negative interest rates.
Since taking over as governor in September, Lowe has highlighted his concern about the risk of lower rates to financial stability, with household indebtedness rising to record levels.
However, the IMF says this should be dealt with by the banking regulator, the Australian Prudential Regulation Authority.
“Concerns about risks to financial stability from low interest rates can be addressed through banking supervision and prudential policies, with a view to curbing excessive leverage by financial intermediaries, firms, and households,” it says.
The fund’s modelling is based on the economy as it stood at the end of last year, with inflation at 1.3 per cent, the economy falling short of potential by 1.3 per cent of GDP and the cash rate at 1.5 per cent, with financial markets predicting at that time that it would drop to 1.3 per cent over the following year.
With the standard reaction of an inflation targeting central bank based on both the current output gap and expected inflation a year away, the cash rate would be lowered modestly and then increased gradually.
There would be a small depreciation in the Australian dollar and a gradual closing of the output gap, but the IMF says the recovery would be slow.
“Under this scenario, inflation stays below the RBA’s 2 to 3 per cent inflation target range for several years,” it says.
“The optimal monetary policy strategy is to respond with a ‘low for longer’ policy leading to a faster return of inflation to target and output to potential.”
This strategy would be based on minimising economic loss, with equal weighting given to underperformance of the economy and to inflation.
“Such a forward-looking policy strategy would put a premium on avoiding ‘dark corners’ in which the economy gets stuck in a bad equilibrium and becomes resistant to conventional policy instruments.
“The policy rate would be cut significantly over a few quarters, falling to 0.75 per cent before it increases gradually.
“As a result, the output gap closes much faster and inflation returns inside the 2-3 per cent target range shortly over the next few quarters.
“With interest rates lower for longer, the Australian dollar depreciates by an additional 6 per cent.”
If Australia is confronted with an external shock, such as a downturn in China, the government should also respond, supporting the economy with fiscal stimulus.
With its conviction that an end to the drawn-out recovery from the global financial crisis is at hand, the Reserve Bank is likely to reject outright the IMF’s prescriptions, and particularly its suggestion that the bank jettison its established way of setting rates according to the expected course of inflation.
Most in the market agree that economic momentum is building and there is little case for further cuts. However, there are a number of economists who think the Reserve Bank still has rates set too high and will have to lower further as labour force, inflation and growth figures fall short of its forecasts.