Current attempts to squeeze back business investment in Australia by raising interest rates to close to double digit levels to deal with what is regarded as an unacceptably high inflation rate of 3.5% are a gamble that continued strength in the Asian economies will more than counteract the impact of a slowing US economy. Monetary policy operates with long and variable lags so this is a risky approach to snuffing out Australia’s biggest private investment boom in two decades.
‘negative real interest rates are most likely to arise if growth expectations are particularly low or if uncertainty is particularly high. Low growth expectations encourage households to save, which drives down equilibrium rates of return. High uncertainty drives up risk premiums, which in turn drives down the return on safe assets, perhaps below zero. Both forces seem to be working now.’
Long-term this Howard-government created investment boom will strengthen the Australian economy by increasing economic capacity. But it is the short-term effects of the boom that the RBA is focussing on.
Specifically the RBA's use of interest rate hikes is is a gamble on a structural change having occurred in the Australian economy which produces lower dependence on the US economy both directly and through what is being presumed to be weaker feedback effects on the Chinese economy from the US slowdown. These indirect effects will impact on Chinese import demands for Australian raw materials.
I suspect too that the RBA are concerned that Mr Rudd's government will provide a more supportive environment within which cost-push pressures from wages can develop. This is not the present situation - inflation is emerging in response to higher commodity and food prices - but if trade unionists can convince the government of the need to 'secure the real wage' in the face of inflation then the long-term expansion of the Australian economy will come to a griding halt with resurgent inflation and unemployment. It is a grim prospect that I assume the RBA see as their worst nightmare.
The Labor government has ended any prospect for further labour market reform and has left as the only means for addressing potential cost push pressures reducing the demand for labour through higher interest rates. Otherwise commodity price shocks would simply be experienced as once-and-for-all factors slowing down demand and could be more easily ignored.