In previous downturns, monetary policy played a major part in helping to get the economy moving. In response to the 1990s recession, Kennedy reminds us, the Reserve Bank cut the official interest rate by more than 10 percentage points. In response to the global financial crisis of 2008-09, it cut rates by more than 4 percentage points.
By now, however, the Reserve has run out of room. In its response to the coronacession, it cut the rate by 0.5 percentage points to 0.25 per cent. This week it squeezed out another cut of 0.15 percentage points and went further in “unconventional” monetary policy measures. That is, printing money.
Why so little room? Interest rates are down to unprecedented lows partly because, as I wrote last week, the rate of inflation has been falling for the past 30 years.
‘Necessity is a great ramrod for breaking down the barriers to technological adoption.’
Dr Steven Kennedy, Treasury Secretary
But Kennedy explains the other reason: the “natural” or “neutral” interest rate has been “steadily falling globally over the past 40 years”. The neutral interest rate is the real official rate when monetary policy is neither expansionary nor contractionary.
(Note that word “real”. Conceptually, nominal interest rates have two parts: the bit that’s just the lenders’ compensation for expected inflation, and the “real” bit that’s the lenders’ reward for giving borrowers the temporary use of their money.
“The declining neutral rate is due to [global] structural developments that drive up savings relative to the willingness of households and firms to borrow and invest,” Kennedy says.
“While the academic research is not settled on the relative importance of different structural drivers, it is likely due to some combination of population ageing, the productivity slowdown and lower preferences for risk among investors,” he says.
Because this is a “structural” (long-term) rather than “cyclical” (short-term) development, “a number of central banks have suggested that interest rates will not rise for many years”.
Kennedy says the size and speed of the shock from the pandemic necessitated a large fiscal (budgetary) response. This would have been true even if a large response from conventional monetary policy had been available – which it no longer was.
Monetary policy is a one-trick pony. It can make it cheaper or dearer to borrow, and that’s it. As we saw with the early measures – particularly the JobKeeper wage subsidy and the temporary supplement to the JobSeeker dole payment – fiscal policy can be targeted to problem areas. “Monetary policy cannot replace incomes or tie workers to jobs,” he says.
So the move from monetary policy to the primacy of fiscal policy is not only unavoidable, it has advantages.
Since the onset of the pandemic, the federal government has provided $257 billion in direct economic support over several years, which is equivalent to 13 per cent of last financial year’s nominal gross domestic product. That compares with the $72 billion the feds provided in economic stimulus during the global financial crisis, or 6 per cent of GDP in 2008-09.
Kennedy notes that fiscal policy is about stabilising the economy’s rate of growth over the short term; it can’t increase economic growth over the medium to long-term. According to neo-classical theory, that’s determined by the Three Ps – growth in population, participation in the labour force, and productivity.
But whereas over the 10 years to 2004-05 our rate of improvement in “multi-factor” productivity averaged 1.4 per cent a year, over the five years prior to the pandemic it averaged half that, 0.7 per cent.
There are many suggested causes for this slowdown (which can also be observed in the rest of the rich world). Treasury research has highlighted signs of reduced “dynamism” (ability to change over time), such as low rates of new firms starting up, fewer workers switching jobs, slower adoption of the latest technology, and fewer workers moving from low-productivity to high-productivity firms.
Kennedy says it’s not clear how the pandemic will affect Australia’s long-run rate of improvement in productivity. But it has the potential to cause some large structural changes in the economy. We’ve seen the way it has forced businesses to innovate.
“Necessity is a great ramrod for breaking down the barriers to technological adoption,” he says.
Remote working is one example. In September, almost a third of workers worked from home most days. If this continues it could have “significant implications for transport infrastructure planning and for the functioning of CBDs”.
An official survey in September found that 36 per cent of businesses had changed the way products or services were provided to customers. The ability to pivot displayed by many firms indicates potential for innovation and adaptation.
On the other hand, there’s a risk that closures among smaller firms will lead to even more market concentration and slower productivity growth. Let’s hope not.
Ross Gittins is the Herald’s economics editor.
Ross Gittins is the Economics Editor of The Sydney Morning Herald.