MICHAEL KEATING. The Future of Monetary Policy

For the last forty years or more, economic orthodoxy has assigned the principal responsibility for macroeconomic demand management in the advanced economies to monetary policy. In recent years, however, inflation targets have been under-shot and incomes have continued to stagnate, while asset prices have boomed. This article discusses how these policy failures have led to increasing questioning of the future role of monetary policy, and the orthodox macroeconomic model on which it is based.

One consequence of the stagflation experienced in the 1970s, was that mainstream economic opinion has ever since assigned the principal role in macroeconomic policy to monetary policy, controlled by the independent experts in central banks. Politicians were not to be trusted to maintain low inflation, and the role of fiscal policy in demand management, which politicians properly controlled, was very much diminished. Some economists even thought that fiscal policy should have no role in stabilising aggregate demand in the economy.

The widespread experience of economic stagnation in the last decade has however led to some reassessment. Interest rates are now near zero – or even negative in some countries – and this has led many central banks to adopt controversial policies of quantitative easing in an attempt to expand the money supply. But despite these attempts at monetary stimulus, inflation targets are not being met, and while unemployment is mostly down, wage growth and aggregate demand are still much less than compatible with realising the past rates of economic growth. On the other hand, asset prices are close to or at record high levels, and their ownership is becoming increasingly concentrated.

In Australia, for example, over the last seven years, from 2011-12 to 2018-19, household incomes increased at an average annual rate of 3.3 per cent, not much more than half the rate of increase of 6.3 per cent achieved over the previous twenty years (Table 1). Furthermore, this stagnation of income growth is getting worse, with household incomes only increasing at an average annual rate of 2.6 per cent over the last four years. In addition, most of this decline in income growth cannot be explained by a reduction in inflation – instead real per capita incomes have declined over the last four years.

On the other hand, over the same seven years since 2011-12, residential property prices in Australia increased at an average annual rate of 6.4 per cent, and the average annual rate of increase in share prices was as high as 8 per cent. Thus, over the last seven financial years the increase in Australian asset prices has been more than double the increase in incomes. Although in the last few years, this rate of increase in both property and share prices has decelerated, it continues to run significantly ahead of the rate of increase in incomes (see Table 1).

Table 1: Growth Rate of Household Incomes compared to Asset Prices.  Average annual percentage growth rate.

Household disposable incomes Residential dwelling prices Australian share prices
1994-95 to 2014-15 6.3
2011-12 to 2017-18 3.4 6.6 8.7
2011-12 to 2018-19 3.3 4.8 8.0
2014-15 to 2017-18 2.6 6.4 3.1
2014-15 to 2018-19 2.6 3.2 3.1

Given this evident policy failure, there is an increasing global debate about the future of monetary policy. Most interestingly, all central banks are calling on fiscal policy to do more. While, even the British weekly magazine, The Economist, which has been a bastion of economic orthodoxy for more than 150 years, declared in a recent Leader, ‘The world economy’s strange new rules’, that in this ‘new normal’ situation where the economy fails to respond to monetary stimulation, ‘the rules of economic policy need redrafting’.

In what follows I seek to elaborate how monetary policy is supposed to work, and why it is failing to achieve the intended results.

How monetary policy is supposed to stimulate demand

The main conventional instrument of monetary policy has been the ability of central banks to determine the short-term rate of interest, and more recently by buying longer-term securities a central bank can directly influence the whole schedule of interest rates from short to long term rates.

The theory was that a fall in interest rates would encourage consumers to borrow more and then spend it, thus raising aggregate demand in the economy. In particular, the demand for housing was assumed to be especially sensitive to interest rates because such a high proportion of housing purchase costs are financed by borrowing. Recently, however, when the Reserve Bank of Australia (RBA) cut its interest rate to 0.75 per cent – its lowest rate ever – a widespread reaction was that if people are not prepared to borrow when the interest rate was already as low as 1 per cent, why would a cut to 0.75 per cent make much, if any, difference.

But in fairness, interest rates were also thought to influence investment. In principle, investment in new capital equipment occurs when the present value of the expected future returns from that investment exceeds the replacement cost of the capital. The interest rate enters this calculation as it determines the discount rate used to determine the present value of returns that will accrue in the future, and which therefore have a lower present value. In addition, the interest rate also determines the cost of the funds used to finance new investment and again it pays to invest if the discounted present value of the expected future returns is more than the cost of the finance needed.

The standard measure of a company’s value is of course its share price, and in principle that share price should reflect the discounted sum of its expected future returns. Consequently, when interest rates fall, normally that will result in an increase in the company’s P/E ratio, which represents the ratio of the share price to that company’s present earnings. In other words, a fall in interest rates can explain at least some of the rapid increase in share prices and the associated increases in P/E ratios that have occurred in recent years. Furthermore, a 2½ percentage point fall in the discount rate from say 5 per cent to 2½ per cent will have a much larger impact on share prices and the P/E ratio than the same percentage point fall from 8½ per cent to 6 per cent. Thus, the falls to what are now very low interest rates can explain quite a lot of the increase to what are now very high P/E ratios.

Nevertheless, business investment has been stagnant over the last several years. Profit rates might be quite high, but the growth of business earnings has also been modest, as consumer demand has stagnated. It is these current business earnings which usually determine expectations about future earnings, and while Australian monetary policy has succeeded in increasing share prices that has not as yet translated into improvements in expected earnings. Furthermore, it is questionable whether business expectations regarding future earnings, and consequently business investment, will ever pick up without more signs of a recovery in consumer demand, and in present circumstances that seems to be beyond the gift of monetary policy.

In sum, the monetary stimulus that Australia has experienced in recent years has succeeded in driving up share prices, despite stagnant corporate earnings. Similarly, much of the relative inflation in dwelling prices reflects the impact of low interest rates. In the past, there is a lot of evidence that restrictions on the supply of land were mainly responsible for the relative increase in house prices, but in the last few years the supply of dwellings coming on the market seems to have been adequate, as the volume of sales to new owner-occupiers has risen much more slowly, suggesting that these sales are being mainly limited by demand, not supply.

The conclusion therefore is that monetary policy in Australia has been much more successful in inflating asset prices than in getting the economy moving again. As Keynes observed a long time ago, when interest rates approach zero, the economy gets stuck in a liquidity trap, and monetary policy is no longer as effective as before. Furthermore, as I discuss in a follow-up article to be posted tomorrow, this increase in asset prices has had the unfortunate effect of driving an increase in inequality which of itself is bad for the future of Australian economic growth and our society.

Michael Keating is a former Head of the Departments of Prime Minister & Cabinet, Finance, and Employment & Industrial Relations. He is presently a Visiting Fellow at the Australian National University.

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