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John Quiggin

Trick is managing a soft landing

John Quiggin Australian Financial Review

8 November 2007

After the bad inflation figures released last month, the Reserve Bank’s decision to raise interest rates by 25 basis points came as no surprise. If there was ever any doubt about the outcome of Tuesday’s meeting it was removed by the rather hamfisted attempts of the Treasurer, Prime Minister and Deputy Prime Minister to persuade the Bank’s Board to hold off any action. Faced with such overt pressure, the Board could not afford to be seen to buckle.

On the other hand, political realities probably ensured that the bold step of a 50-basis point increase in rates, advocated by some commentators, was never going to happen.

The rate increase has created plenty of headaches for the government’s election campaign. It certainly casts doubt on the wisdom of putting the election off so far beyond the customary three years. With this week’s news cycle dominated by interest rates, the time for a turnaround in the polls is running out.

The government’s response has been to argue that, while it has no control over interest rates, its skills in economic management are needed to manage a less favourable international economic environment. This argument seems counterintuitive, and is very different from that presented in 2004, when lower interest rates were seen as the prime indicator of good management.

Still, the argument is worth taking seriously. Certainly, the incoming government will face serious problems with interest rates. And, the commitments made in this election campaign will increase the problems in formulating a response.

There is every chance that the Reserve Bank has further to go in the current tightening phase. And with the increase in risk premiums arising from the subprime meltdown in the US, it seems likely that banks will add their own increase in margins. The size of this increase will depend on the extent of the bad news coming out of the market for collateralized debt obligations, many of which are based ultimately on mortgages.

The recent news here has been worrying. Banks such as Merrill Lynch and Citibank, having already announced writedowns of billions of dollars when the subprime crisis broke, have now announced larger writedowns with the prospect of more to come. The departure of the CEOs of both companies is a reminder to John Howard and Kevin Rudd that, regardless of the ultimate distribution of responsibility, the buck stops at the top.

The result is that, although the liquidity crisis that seized financial markets in August has been resolved, the market for mortgage backed securities has collapsed, with commercial property being affected even more than residential. This is bound to feed into higher interest rates for mortgage borrowers in the medium term.

More generally, it seems likely that the long period of cheap money that has driven, Australia’s housing boom, is drawing to an end. Although the US Federal Reserve has cut rates in response to the subprime crisis, the general tendency of global interest rates is upwards.

If inflation remains in the target band of 2-3 per cent sought by most central banks, while cash rates stay around 7 per cent, the implied real rate of interest is 4 to 5 per cent. At this level, well in excess of the rate of growth of income, investment strategies and household budgets based on high levels of debt become unsustainable. What can’t be sustained won’t be. We can therefore expect some of the massive imbalances in the world and Australian economies to be unwound over time.

This process is already beginning in the US. House prices are falling, and the resulting wealth effects are reducing consumer spending, with a likely flow-on to consumer demand. The decline in the construction industry frees capital for investment in the export sector.

Finally, thanks to the decline of the US dollar against most major currencies, the massive trade and current account deficits of the last decade are starting to unwind. The process of adjustment is likely to be painful, but most commentators say the odds are still against a recession.

Australia has yet to begin this process of adjustment. While the Reserve Bank has long been concerned about the risks inherent in the housing boom or bubble, the Howard government has encouraged the boom with capital gains concessions, help for first home buyers and vocal cheerleading. The opposition has generally supported these moves. The task now is to manage a soft landing under difficult conditions.

The choice facing voters is whether to trust the incumbent government to resolve problems to which its own policies have contributed, or to hope that Labor’s alternative team can do better.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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