Cash rate a ‘blunt tool’, says RBA

Addressing the National RSL Clubs Conference in Hobart yesterday, RBA assistant governor Christopher Kent said that at a time of subdued economic growth it is tempting to think that economies are well served by being directed or guided in a way that will produce better outcomes.

“Monetary policy is certainly playing an important role, but it guides things rather imprecisely, with the relatively blunt tool of the overnight cash rate,” he said.

The central bank’s recent update to its forecasts has pushed out the time at which it sees GDP growth picking up from its current sub-trend pace.

“It is not that economic growth has weakened of late,” Mr Kent said, “but there is little to suggest that it will increase in the near term.”

This implies that the unemployment rate will rise for a bit longer and peak a bit higher than previously expected, he said.

“The question then is what is it that will generate an improvement in the rate of economic growth and lead to a decline in unemployment? What are the triggers for such a revival?”

After admitting that monetary policy can only go so far, Mr Kent said economies are responsive in many other ways that do not require the active input of policy makers.

“The so-called ‘invisible hand’ of markets can provide the incentives for producers and consumers to alter their behaviours via a range of price signals,” he said.

“The exchange rate provides one such signal.”

After depreciating by nearly 20 per cent (on a trade-weighted basis) since its peak in mid-2013, the Australian dollar is starting to play a role in helping the economy to adjust, Mr Kent noted.

“Australians and foreigners will direct more of their spending to Australian-produced goods and services (such as tourism and education) as they become relatively cheaper compared with the alternatives available offshore,” he said.

“Along the same lines, the depreciation has lowered the level of Australian wages when measured in foreign currency terms; since April 2013, they are 30 per cent lower in US dollar terms.”

While the depreciation seen to date will be helpful, the RBA’s assessment is that our exchange rate remains relatively high given the state of our overall economy.

A change in the growth of wages (in Australian dollar terms) is also an important source of adjustment, Mr Kent said.

“Just as wage growth picked up when conditions in the economy were stronger, the growth rate of wages has declined substantially since 2012,” he said.

“The lower growth of wages works to depress the growth of incomes for those in employment. At the same time, however, lower wage growth allows for more employment than would otherwise be the case, which works to support the growth of total labour incomes. In a similar vein, the pick-up in productivity growth over recent years means that the cost of obtaining the labour required to produce a unit of output (the unit labour cost) has not changed for three years.”

The RBA acknowledges that the economy is currently operating somewhat below its productive capacity.

The central bank's forecast is for a gradual increase in the growth of demand and employment, and eventually a rise in non-mining business investment, supported by the very low interest rate environment.

The lower exchange rate is also expected to offer some support to demand for Australian-produced goods and services.