Why monetary policy should be ‘last resort’ for economic management, not the first.

On 30 August 2019, we released an article ‘Will QE tear apart Australian Society?’ In this article we forecast that should the RBA undertake quantitive easing (QE), it would increase the gap between the haves and have-nots from a personal wealth perspective. We also forecast that QE would cause asset prices in property and shares to be substantially inflated, and fixed interest holders would be decimated, unable to generate a return above real inflation rates.[SA1] 

When COVID hit Australia in early 2020, our central bank, the RBA, unleashed QE. The side effects of this policy were in line with our forecasts, with property rising 20% and shares seeing massive swings upwards. As warned in our article, the gap between the haves and have-nots from a total wealth perspective expanded massively.

Looking back now, it is clear the RBA stimulus was largely unnecessary and resulted in a trainwreck, with runaway inflation rates not seen in decades, largely driven by runaway money supply injected by the bank using M2 as an economic proxy.

It seems both the RBA and the government at the time completely forgot about the founding principles of M2 economy policy theory.

Today, there is now a desperate race to try to control inflation and we have seen interest rates move from close to 0% in Australia to 3.1% at the time of writing. These consecutive rate rises have moved at a breathtaking pace never before seen in the history of the RBA.

Despite the RBA governor saying the markets were wrong and that rates will stay low until at least 2024, Australian consumers are now bearing the brunt and hardship from this policy misstep by Reserve Bank Board members, with interest rates on mortgages increasing and the cost of living skyrocketing.

So, why do we need a central bank to start with?

Our view is a little cynical.

If a central bank such as the RBA puts up interest rates and imposes financial pain on the local population base that has a mortgage, the government can blame the central bank, stating it is an independent body and outside their control. The RBA is an independent body and is permitted to make monetary policy changes under their mandate of managing inflation. These policy changes we typically classify as ‘monetary’ policy.

The other option is the government cuts somebody’s entitlements to reduce budget spending; however, when the government inflicts this type of financial pain it is usually not well received by the public. This type of policy change we call ‘fiscal’ policy.

Since publishing the August 2019 article, we raised the idea that monetary policy is a blunt instrument, and government fiscal policy would be a more effective tool to manage the economy and would also have less of a social impact.

We also believe that changes through monetary policy are not equally distributed through the population; there are usually winners and losers from such changes.

For example, if interest rates go up it hurts homeowners with mortgages but helps retirees, and vice versa when rates drop.

The reality is that in more recent Australian budgets, the government has literally torn through $79.8–$134.2 billion per year in providing services to the Australian population that were well beyond its means, and providing a wide range of services and offers that Australia simply could not afford.  

This additional spending is stimulatory in nature to the economy and creates a wealth transfer from the government to society through the provision of payments and services.

We have seen government structural spending reportedly running at around 27% of GDP – at least $50 billion higher than pre-COVID levels – so, despite our economy running at record-high levels, the government is still spending like mad.

So, why is this an issue and what are the opportunities?

Well, it is like driving your car down a highway and trying to use the handbrake to slow down. In this case, the central bank is pulling on the handbrake, while the government has their accelerator pedal to the metal.

Prudent management of fiscal policy used to be based on the notion that governments inject stimulus during periods the economy needs to be supported, and then winds it back during periods the economy is booming. These days, this is not the case.

Would it not be wiser to simply ease off the accelerator and slow down a little? Fiscal policy changes can be directed so they are more evenly distributed across the population base.

Our view is it would make sense for the economy to first be managed correctly by the government from an economic standpoint. It would also be prudent that the government install ‘guard rails’ around fiscal policy as the primary tool, so that it cannot overstimulate an economy when it is not required, based on a number of key economic indicators.

If these tools were to fail, then would be the time to look at monetary policy as a second option – a position of last resort – thereby leading the country from a leadership standpoint rather than outsourcing the management of the economy to the RBA and just keeping on giving people what they want, no matter what the economy looks like.

So, next time you look at your mortgage statement and get a little angry that you have been hit with another interest rate rise, or seeing the cost of a household item jump up in price, remember there is another option that the government managing the economy could consider.

 It's unclear here if you mean this would happen if QE was activated, or if it was going to happen anyway? I assume the former applies and have changed it, but please check.

Suggest explaining what M2 is.