Why are interest rates going up - Tim Colebatch explains

WHEN interest rates were low, the Howard Government claimed the credit, and was given it by grateful voters. Now that rates have risen, and are set to rise still higher, should it take the blame?

In part, no. In part, yes. Interest rates in Australia were bound to rise. Some of the factors that have pushed them up were desirable, others unforeseeable. And in two crucial areas, it has taken pressure off interest rates.

But interest rates have risen more than they would have had the Government treated "keeping interest rates low" as a policy priority, and not just a slogan. It has neglected key jobs, thrown money where it buys votes rather than where the economy needs it, and turned off the "automatic stabilisers" by which budget policy usually takes pressure off interest rates.

As Access Economics director Chris Richardson put it recently: "The Government is throwing money into the economy and the Reserve Bank is taking it out again. We have one foot on the accelerator and the other on the brake. No wonder we're blowing smoke."

There are more important issues for the economy, but certainly there is no economic issue more important for voters. The average new home loan in Melbourne is now approaching $250,000. Add the five interest rate rises since the 2004 election, the sixth likely next month, the seventh expected early next year, and the banks' plans to raise margins, and the monthly payments on that loan would be up almost $400 a month since John Howard pledged to keep interest rates low.

Howard keeps pointing out that they were higher in the past, and so they were. But the people who remember the 17 per cent rates are not the ones paying big mortgages now. They remember when mortgage rates were 6 per cent. Now they are looking at paying 9 per cent. Talking about what went wrong in the 1980s won't solve that.

Nor can the Government credibly use its old line that interest rates are higher here because we are growing and the rest of the world isn't. The International Monetary Fund has just updated its database, and it shows that between 1996 and 2006, of 30 advanced economies, Australia ranked exactly 15th in economic growth per head. The economy overall grew 14th fastest out of the 30 over that decade. Our unemployment rate is now the equal 14th lowest of the 30. A standout? Not us: we are the average Western country.

The Government can defend its record on three grounds. First, as Peter Costello keeps telling us, growth is the goal of economic policy — and one of the things growth does is that it raises interest rates. As the economy grows, fewer resources are left unused, competition for them increases, and their price rises. We could let prices rise to create an inflationary spiral — or try to ration resources by raising interest rates. That's the low-cost option.

Second, Australia's economy has been hit by an X-factor that no one saw coming: the mining boom. Last year half of all the growth in construction across the country was in Western Australia. Mining investment has more than doubled in two years, and is still surging. In mining and construction in the west, everything is in short supply, prices are rising rapidly, and the ripples are reaching the east too.

Third, as Costello and Howard now concede, WorkChoices was designed to slow the pace of wage growth. Tilt the bargaining rules in favour of the employer, as they have done, and you get smaller wage rises and hence less inflationary pressure. Whether it is fair or unfair is another matter, but as Reserve Bank Governor Glenn Stevens says, anything that frees up the labour market helps to hold down inflation.

The same is true of the controversial section 457 visas used to bring in contract workers from overseas wherever employers identify shortages. While it would be better to retrain some of the million or more Australians who are unemployed, underemployed or prematurely retired, it is a low-cost way to cut through inflationary bottlenecks.

But in other ways, the Howard Government has made inflation worse, and helped push interest rates up. On skills training, it dropped the ball in its first budget. Many of its cost savings came from scrapping Working Nation, set up by the Keating government to retrain the unemployed so that, as recovery came, Australia would have the skilled workers to meet its needs. That ball remained dropped until recently.

In 2005-06, the OECD Employment Outlook records, Australia invested just 0.04 per cent of its GDP in training the unemployed, the third lowest among the OECD's 25 rich members. By then, skills shortages were already acute. Skills shortages cause wage rises which cause inflation which causes higher interest rates. On this one, Howard's Government has no excuse.

Second, instead of using budget policy to ease pressure on interest rates, as in the past, Howard has increased the pressure by shovelling money into voters' pockets while the Reserve tries to slow their spending. On Treasury projections, personal income tax will shrink from 12.1 per cent of GDP in 2004-05 to just 10.3 per cent in 2008-09 — adding $20 billion a year to consumers' spending power.

In past booms, monetary and fiscal policy have worked together. More jobs and higher wages increased tax revenues, reducing the need for rate rises to slow the economy. Now the Government has dropped its end so it can deliver big tax cuts.

That means interest rates have to do all the work. So as taxes go lower, rates go higher.

Tim Colebatch is The Age economics editor.


This story was found at: http://www.theage.com.au/articles/2007/10/29/1193618793576.html