The RBA’s rates riddle

This is a message for Glenn Stevens, Reserve Bank of Australia, 65 Martin Place, Sydney, NSW.

Interest rates did not cause the recent catastrophic floods in Queensland, nor did they cause the 14-year droughts, or the demand for iron ore by emerging economies such as China and India. Nor do they have any impact upon the price of bananas, or any other product or service – unless they are so high that they send businesses and people bankrupt. What affects the price of goods, believe it or not, is the extent to which supply is in excess of or less than demand.

Mr Stevens, just check how much you paid for your most recent computer or video camera or memory stick, or any other piece of technology that has found its way into your household. Were interest rates responsible for the dramatic decline in prices that are racing to the bottom? The cause for the continuing decline in prices is the ability to produce abundance.

The conventional wisdom that interest rates can control the economy and inflation is stupendously flawed in much the same way as many conventional wisdoms have been flawed, such as the Ptolemaic theory (believed for 1,500 years) that the earth was the centre of the Universe.

Following is a graph of three of the major contributors to inflation since September 1972:

If managing interest rates controls inflation, how can it be explained that despite the ups and downs of interest rates over this period, the progression of increase in cost has been almost linear. Since 1988 (when interest rate management of inflation became a key policy) the increase in all of these indices has been dramatic.

Following is a graph of two other components of the CPI, small and large household appliances for the same period. The two components traced one another until 2000, presumably because the ABS didn’t differentiate.

Have a look at the graph for computing prices:

As against the prices for water and sewerage:

So the question is: Why have the cost of appliances and computing dropped in an ongoing inflationary environment, while the cost of local government has gone through the roof, along with the cost of housing, rents and food (to a lesser, but significant extent)?

The Reserve Bank takes the credit for controlling inflation but when there are components of the CPI such as household appliances and computing reducing in cost irrespective of the interest rate, the Bank should be careful not to take too much credit.

Interest rate increases and decreases have obviously had no effect on the price of food and local government. The reason is that there is no competition in these industries. The food distribution industry is largely in the hands of an oligopoly. I am sure that if the ABS took the food prices at the Victoria Market as the basis for calculating the index on food, they would come up with a staggeringly different number. For instance, the price of carrots over the past 10 years, with some seasonal variation has been $1.00 a kilo.  Two liters of milk at a nearby market costs $3.87 and in the supermarket next door it is $4.67.

Local government has no competition and has become a bureaucratic nightmare. Just try getting approval for erecting a glass balustrade on Cremorne Point, not to mention getting approval for the development of a block of apartments. The deterrent to property development because of administrative and bureaucratic hurdles and protected remuneration of unskilled workers results in delays in bringing housing to the market. Limited supply, results in increased costs and no amount of interest rate interfering has or will alter this state of affairs.

There is a limit to the amount of food that can be produced and that limit is challenged by a dramatic increase in the population of the planet and the consequences of climate change. This is compounded by a distribution outlet in the hands of a few players. If there is a shortage of food, it doesn’t matter what the interest rate is, the price will go up.

Now, it might be said that the Chinese industrial revolution is responsible for the decline in prices of household appliances and computing, but the more fundamental explanation is that concentration on quality controls and manufacturing innovation has ushered in the age of abundance seeking abundance. Efficiency in quality production has resulted in products coming to market in such abundance that it is increasingly possible to reduce price, sell more and make more money.  An MRI machine is much more complicated and far less tolerant to error than a house and yet the price of the product had dropped dramatically in the past few years while the quality has increased. No help from the Reserve Bank.

In the past 240 months, there have been 56 interest rate alterations. In other words, in 20% of the period since 1990, the Reserve Bank has interfered in the interest rate market. The following graph indicates the yoyo gyrations of official interest rates:

In the late 1980s and early 1990s, interest rates of 22% really did the trick. They brought the country to its knees and sent people bankrupt and caused people to lose their houses. Since then, interest rate management has been largely irrelevant to the management of the economy as the following graph indicates (being the change in CPI since 1990):

One would really expect some correlation between official interest rates and the CPI. However, after some trouble I was able to put together the following graph of the alteration in interest rates by the Reserve Bank and the CPI. The following is the result:

If this graph is the outcome of Reserve Bank interest rate policy, so help me! Businesses that see graphs like this wonder if they are going to survive. The multiple attempts by the Reserve Bank to influence the economy are reflected in the numerous gyrations of their rate setting. If you were in a business and looked at a graph like this, you would conclude that whoever was involved simply didn’t know what they were doing.

On the other hand, since about 1990, inflation has been less volatile and the amplitude of the graph much less which suggests that inflation is pretty much in check (apart from the cost of housing, food and government). The coincidence of the Chinese phenomenon and ever decreasing cost of technology with the reduction in inflation around about 1990 is not surprising. This phenomenon of ever-reducing prices is a factor that has been insensitive to the frenzied and inconsistent interference with the official rate by the RBA.

Peaks in inflation are almost always caused by one of two factors; irresponsible bank lending or a commodity scarcity such as oil (coming up there will be a scarcity of bananas). In the meantime, the RBA sits on the sidelines, trying to make some sense of an incomprehensibly complex phenomenon called “the market” and pretends that by adjusting the “official” rate by 0.25% everything is going to be fine.

The banks (once again an enormous oligopoly) have woken up to the charade and fix their own rates according to their cost of money and what they think the market will stand. As interest rates go up so does the cost of money and hence inflation, with the result that increases in interest rates (until they are ruinous) adds to inflation like the cost of any other component of a product.

The next time we have a fire or a flood or a commodity scare or a bubble as a result of bank over-indulgence, interest rates are not going to fix the problem. If you look at the last graph it is difficult to avoid the conclusion that if the RBA left the “official” rate at somewhere under 5%, the market would sought things out.

In the meantime, looking at the cost of government and pondering the consequences of our main industries (government, banking, commodities and food) being in the hands of oligopolies might result in a more meaningful result for the Aussie battler.

So, Mr Stevens, when bananas become scarce, just accept that juggling interest rates will not grow any more bananas!

Lou Coutts left law and became a successful entrepreneur. He has qualifications in Advanced Management from Stanford; turnarounds and strategic alliances from Colombia; International Marketing from the University of California and Changing Strategic Direction from the Kellogg Graduate School of Management in Chicago.