Wednesday, October 5, 2022

Bill Mitchell — RBA tom foolery continues while spending continues unabated

It’s Wednesday where I examine in short a few items that came to my attention in the last week and then retreat into the music segment. Yesterday, the Reserve Bank of Australia raised interest rates for the sixth time since May 2022. This time the increase was 0.25 per cent and the current cash rate target is 2.6 per cent. The below-expected increment has been hailed as the first central bank to ‘turn’. It tells me the RBA is now scared it has gone too far in its ridiculous show of power. It is also obvious that spending is not really responding yet to the RBA move which means that they have no real idea of what the impact of their shift in rates has been. That is the problem with relying on monetary policy as a counter-stabilising tool – it works (if at all) with long lags and by the time you see any impact it might be too late....
The countercyclical effect of interest rate increases is lagging as rate increases work through the economy, e.g., depress RE sales owing to increased carrying cost. In fact, there is evidence that interest rate rises dampen the economy through the housing channel.

But being a price increase that increases fiscal injection through interest payments on government securities, effect of the central bank raising the interest rate is immediate and procyclical. More interest income is injected into the economy. 

The full amount of this fiscal injection will not all go toward spending, but some will be committed to financial investment. Financial investment is a form of saving, and not to be confused with firm investment, which is a form of spending. But if market prices rise as a result, so will the "wealth effect," which has an inflationary bias. So there are contradictory aspects of central banks' raising interest rates. This is generally overlooked. 

According to the conventional thinking, interests rate increases lead to curtailed investment that results in cut backs in hiring and eventually layoffs. This reduces the wage pressure that is assumed as the cause of inflationary pressure. 

This is a from of "single-variable" thinking, which is illogical with respect to systems with more than one major causal factor. Modern economies are not simple systems, as Keynes observed. 

The interest rate is not a single independent variable that determines the price level at full employment, so that raising rates is entirely countercyclical. There are procyclical fiscal effects as well.

Bill Mitchell – billy blog
RBA tom foolery continues while spending continues unabated
Bill Mitchell | Professor in Economics and Director of the Centre of Full Employment and Equity (CofFEE), at University of Newcastle, NSW, Australia


Ahmed Fares said...

The Bank of Canada lists four channels of monetary policy transmission:

Four transmission channels

When we adjust our policy interest rate at the Bank, we don’t expect immediate results. It usually takes 18 to 24 months to see the full effects. Interest rate changes affect the economy through four main channels:

.commercial interest rates—what you pay on mortgages and loans and what you receive on deposits
.the Canadian dollar exchange rate
.people’s expectations for inflation
.the prices of assets such as houses, stocks and bonds

source: Understanding how monetary policy works

So while it's true that higher interest rates get passed along in the price of goods and services thereby contributing to inflation, what matters is the net effect of all these changes which is assumed to be deflationary.

Matt Franko said...

Increasing the risk free rate immediately reduces the NPV of FINANCIAL assets but at the same time can increase the observed prices of REAL products..