A better tool for Australian monetary policy

With house prices running away and averaging 20% across Australia, it is clear that the Reserve Bank will have no option but to again increase interest rates today. No option because the situation is unsustainable, and the RBA has only this one tool in its armoury.

But is it the best way? I believe there is a better way…

To understand this, first what is the aim of rates rises?

The stated core purpose of the RBA is to keep inflation within a target band. It does this by either encouraging more spending when markets are in decline—such as during the so called Global Financial Crisis—or damping spending patterns when markets become ‘overheated’, through moving interest rates down or up respectively, to alter the funds people have left over after essentials for ‘discretionary spending’.

Does it work?

As we saw during the GFC, downward rates result in very quick market upturns. To be fair, the recent upturn conveniently coincided with a rapid fall in consumer electronics prices, giving media their much-abused cliché of the ‘plasma-led recovery’.

But upwards rates moves appear to result in much slower decreases in consumer behaviour. Successive increases are needed before any overall impact is evident from the most important targets – those with relatively high discretional spending power. People with average to high household incomes—unless they are walking a fine line with debt levels—can often withstand several rates rises without appreciably affecting their spending patterns.

In the meantime, households on lower incomes are hurting. The threshold is much lower for them, with household finances always on a tightrope. Rates rises quickly put these people on the precipice, and some people are pushed over the edge. Mortgage foreclosures, family breakdowns, and even suicides quickly follow. Along the way, the children of these households quickly become accustomed to seeing their parents unemployed and without purpose, an unfortunate lesson that often locks them into similar futures.

And there is the key problem with using interest rates as a monetary market tool: it has to hurt some people—those already least well off—very badly before it comes close to achieving the desired effect of restraining the behaviour of everyone else.

Along the way, the additional interest income goes into the banks. Numerous commodities with ‘inelastic demand’ such as fuel and food go up in price, driving up other products due to increased transport costs and the like. This further inflation in turn pressures the RBA to move rates up even more.

The RBA’s only tool is a very blunt tool indeed.

A better tool would:

• have minimal impact on people with low incomes, on social security payments and age pensions
• not itself exacerbate inflation through driving up prices
• leave people’s earnings with them rather than shifting them to banks, while still reducing their spending power
• immediately restrain that spending power proportionately more as incomes increase.

The tool that would achieve this is a variable employee contribution to superannuation.

All employee superannuation funds would be topped up by a mandatory percentage of their gross salaries—a pre-tax deduction managed by their employers in much the same way as employer contributions are handled.

In times of rising inflation, the RBA could mandate increases to the contribution rate. People would not be getting paid any less, and they would not be paying any more out, but their spending power would be quickly reduced—the more they earn, the more the reduction.

Similarly, in troubled financial times, the contribution rate could be reduced, driving up spending patterns.

The sheer immediacy of this measure, plus its direct targeting, would mean that far fewer and lesser variations would be needed to achieve the desired outcomes. And people on lower incomes would be largely shielded from the impacts.

To implement the change would require a transition mechanism. A base contribution rate would be needed at the outset, so as to allow for variations either up or down. This would be offset in the transition by a partially matching reduction in employer superannuation contributions. There should be a slight increase in overall superannuation savings resulting from the initial contrbution transition, because there is already clear evidence that we aren't saving enough to adequately fund our retirements, and to eventually free Australia from funding age pensions.

I wonder whether RBA boss Glenn Stevens would consider such an alternative?