Lift interest rates to avoid secular stagnation

World economy So-called secular stagnation means the US Federal Reserve may have to keep interest rates lower for longer to revive the American economy.

As expected, the Reserve Bank of Australia left the official short-term interest rate unchanged after this week's board meeting.

The decision reflected the concern expressed recently by the bank's deputy governor, Philip Lowe, that rate cutting was no longer delivering the degree of stimulus to activity that it had in the past. It also reinforced the oft-misunderstood reality, expressed by former US Federal Reserve chairman Ben Bernanke in his first blog for the Brookings Institution, that the idea that low interest rates are set by the central bank is true only in a very narrow sense.

In the US, the Fed sets the benchmark nominal short-term interest rate, as the RBA does in Australia. But, as Bernanke says: "What matters most for the economy is the real or inflation-adjusted interest rate (the market or nominal interest rate minus the inflation rate).

"The Fed's ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth - not by the Fed [or the RBA in Australia]."

Canberra is not without some economic clout, but it is inhibited in its economic management capacity by the fact that Australia is a medium-sized, open economy with an export base overwhelmingly focused on commodities. The political environment has evolved away from infrastructure investment towards service-based activities that reflect our changing demographics such as welfare, health and education. China gave us a historic boom, but that is over.

Only the US has the firepower to lift the global economic tempo. But the US economy has reached an inflection point. It has a central bank sailing into uncharted waters as it sets out to normalise its monetary policies. Success is by no means assured.

The historically low level of interest rates is indicative of a worried and apprehensive global marketplace. Bernanke points out that these low interest rates are not a short-term aberration, but part of a long-term trend.

The task of normalising monetary policy - a project that will, if successful, pave the way for a wider economic renaissance - falls to the Fed Reserve. Its strategy - as outlined in late March by the bank's chairwoman, Janet Yellen, at a San Francisco conference - will involve targeting what is called the equilibrium real rate.

It's also called the Wicksellian rate.

This, as defined by Yellen, is typically viewed as the level of short-term interest less inflation, estimated to be consistent with maximum employment and stable inflation in the long run, assuming no future disturbances to the economy. Many factors affect the equilibrium rate, which can and does change over time. Implementing such an economic strategy is not unlike Deng Xiaoping's description of crossing a river by feeling the stones with your feet.

However, that is how the Fed intends to guide its economy back to the new normal for monetary policy.

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Max Walsh


Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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