I grew up in Perth, where the minimum temperature almost never goes below 1 degree. Even in the depths of winter, the maximum daily temperature is usually in the teens. There’s not a lot of need for heavy jackets or thermal underwear. It never snows.

Now imagine I travelled to Siberia. Having never needed thermal underwear or gloves before, would it be right to conclude that I wouldn’t need them in Siberia? Clearly not. Walking around Oymyakon in jeans and a hoodie would be a recipe for a rapid and unpleasant death. The fact that I’d endured countless Perth winters with only a jacket would be no defence against the cold.

In a Perth winter, a jacket and jeans might be enough to stabilise my temperature. In Siberia, I’d require much more. The ‘neutral’ clothing differs depending on the circumstances. Just as it makes sense to adapt to your circumstances when getting dressed, so does the Reserve Bank need to adapt to changes in the economy.

Central bankers generally think there’s a “neutral” rate of monetary policy – one that is neither stimulating nor slowing down the economy. The problem is that this neutral rate is changing all the time. Shifts in the global economy, or in the behaviour of Australian businesses and households, affect the neutral level of Australian interest rates.

Say the neutral rate was 4.5%, and the cash rate was set at this level, so it was neither heating up, nor cooling down, the economy. Then things change – foreign central banks loosen monetary policy, commodity prices fall but the exchange rate stays high, banks widen their margins – and the neutral rate falls. Let’s say it falls to 3.5%. Now, a 4.5% cash rate would be contractionary – it would tend to slow down the economy. In these circumstances, the Bank could cut the cash rate from 4.5% to 3.5% and it would just be keeping monetary policy neutral.

In these circumstances, it would make no sense to just compare the cash rate to its historical levels and declare that it’s at an emergency low. This would be like me showing up in Siberia and saying “I’ve never needed gloves in the past, why would I need them now?” If your circumstances have changed, you should respond to them, and not just rely on your history to guide you.

I think this is the point that Glenn Stevens was trying to make, in his central bankerly way, when he appeared before the House of Representatives Economics Committee a few months ago.

The committee chair asked Stevens the following:

The cash rate is three per cent. As you said in your opening statement, they are getting towards where they were at historic lows. When we spoke to you when they were at historic lows, you were very keen
really to start bringing them back up as soon as you could because you felt they would create distortions et cetera, yet you seem more comfortable now with them sitting at three, and I am wondering what the difference is between where we were last time they were down here and this time.

He responded:

If we then come along to where we are now, we have had pretty reasonable global economic growth overall in the ensuing period, but we have had, I think, this prolonged period of very low rates in the major countries that is having an effect on interest rates everywhere in the world, unavoidably. I think it is clearer and clearer as time goes by that we have the household sector in particular looking to behave differently in its borrowing and saving behaviour. I think it is appropriate that it does, but that is quite a material change. And, of course, in the present setting, we have had the resource investment boom of very, very large proportions, but we are now facing that starting to tail off. We have fiscal policy tightening. We have the exchange rate, unlike 2008 and 2009, not falling. It has remained very high. That is relevant. So with all these things, at least at the moment, my sense is that the appropriate interest rate for the economy’s circumstances is in fact the pretty low one we have, not because we face an emergency like we did back then but because we face some other forces of a more slowly evolving nature that combine to mean that the correct rate really is lower than it was a couple of years ago. So I am not uncomfortable with this setting of rates.

The cash rate is now lower than it was during the GFC, but that doesn’t mean that the RBA thinks we’re facing a deeper crisis in 2013 than the one that loomed in 2008. It just means the circumstances have changed. The neutral monetary policy setting is now lower than it was then. The RBA is still clearly on the stimulatory side of things – the cash rate is lower than neutral – but it’s wrong to conclude that this means we’re at “crisis levels”.

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