Joe Hockey On The Trade-Off Between Fiscal & Monetary Policy

Shadow Treasurer Joe Hockey is right, spot on, 100% accurate.  

A friend passed to me Mr Hockey’s Op Ed piece from September 2010 (http://tiny.cc/hqt2o ), in which Mr Hockey noted:

• “I have consistently argued that there is a tradeoff between fiscal policy and monetary policy.  The two arms of policy together determine the total amount of stimulus that the government sector imparts to the economy.  When the economy is approaching the full utilisation of its resources, then either fiscal policy or monetary policy must be tightened.  Otherwise there is a real risk of the economy overheating and inflation getting out of control.”

It’s good to see Mr Hockey talking sensibly about economics and not playing petty politics with matters as important as fiscal and monetary policy. 

He noted at the time that monetary policy was being tightened – which was true, but he failed to acknowledge that fiscal policy was also about to deliver a dramatic tightening as well.  With recovery locked in, the RBA was (its words) removing the “emergency” level for interest rates and the government was moving the Budget back to surplus.

And sure enough, a couple of weeks after Mr Hockey’s piece, in November 2010, the RBA hiked interest rates.

History shows that that was the last interest rate hike in that cycle with the cash rate peaking at 4.75%, some 200 basis points below the level prevailing when the Liberals left office in November 2007.   For the mortgage rate, it was 8.55% when the Liberal Party lost the 2007 election compared with a peak of 7.8% after that RBA hike in November 2010.

Mr Hockey noted also that:

• “The tradeoff between fiscal and monetary policy has been confirmed by both the Treasury and the Reserve Bank.” And he quoted Treasury’s David Gruen and the RBA Governor Glenn Stevens.

Good people to quote on that issue as they are helping to pull the levers when it comes to fiscal and monetary policy settings.  

Fast forward a year and we know that underlying inflation has fallen sharply - to around its lowest level in a decade.  That overheating Mr Hockey was fearing was nipped in the bud by tighter policy.  But with inflation in check and falling, the RBA started an interest rate cutting cycle in November 2011.  The mortgage rate is now 7.3% - some 125 basis points below the level prevailing in November 2007 and a little below the level when Mr Hockey's Op Ed article was published. 

This must mean that in terms of the policy trade off discussed Mr Hockey, fiscal policy is tighter.  More on that below.

Getting back to the first comment from Mr Hockey, if we look at what has been happening in more recent times, it could very reasonably and accurately be rephrased to say:

• “The two arms of policy together determine the total amount of contraction that the government sector imparts to the economy.  When the economy is in a position where tight fiscal policy is working to free up capacity in the economy, then monetary policy may be loosened.”

If we look at the fact that interest rates have been cut by 50 basis points since November 2011 (and a further 100 basis points or so of interest rate cuts are priced into 2012), fiscal policy must be doing a good job to free up capacity in the economy and allowing for easier monetary policy.

At this point, I am reminded of the hard facts in the Government's Budget settings:

• Real government spending fell in 2010-11 – this was the first such fall since 1988-89.  (Aside – neither the Howard not Fraser Governments ever delivered a Budget when real spending fell.)

• The Budget balance is contracting by a never-before-seen 4.3% of GDP in three years in a clear sign of fiscal tightening.

What’s more, the RBA has noted that fiscal policy is “contractionary” – a sure sign that Mr Hockey is right to articulate a fiscal and monetary policy trade off.  The lower interest rates delivered in recent months are indeed a trade off against the tight fiscal settings delivered by the Government in the last couple of years.