The Political Economy of Interest Rates

I have an oped in today’s AFR on the politics and economics of interest rates. Copy over the fold.

Interest Scares Shouldn’t Rate, Australian Financial Review, 9 Aug 2007

Another RBA decision, another dose of rate rise rhetoric. Did you know that rates are now higher than they’ve ever been this millennium? Or that the last time the cash rate was this high, the Spice Girls were on the pop charts, Fitzroy was still in the AFL, and most Australians had never used the Internet?

Economically, there is little to complain about with the RBA’s latest decision. In announcing that the cash rate would increase to 6.5 percent, Governor Glenn Stevens pointed to the upswing in underlying inflation, coupled with high capacity utilisation, strong business confidence, and relatively low unemployment. It’s difficult to imagine that there was much wrangling among board members about the economic fundamentals.

A tougher question is whether the RBA should have waited until after the federal election to raise rates. For two decades, it has been an unwritten rule that rates do not rise in an election year. While yesterday’s decision broke that rule, the alternative may well have been worse. In the face of an overheating economy, should we expect the RBA to wait for a non-election year before taking action? Just because of our ridiculously short three-year election cycles, it’s hard to see why an independent central bank should be forced to put monetary policy on ice one-third of the time.

Politically, the challenge for the Howard Government will be to deflect questions about interest rates. In 2004, Howard opened the campaign by asking voters “Who do you trust to keep interest rates low?”. Although a Reuters survey of 14 financial market economists found that none believed the party in government would affect interest rates, many felt that interest rates were critical to his victory.

Perhaps they were, but not directly. While some commentators argued that mortgagees were responsible for Latham’s loss, the evidence provides little support for this. Analysing seat-by-seat swings, Newcastle University researchers Steve Easton and Richard Gerlach found that (holding constant voters’ level of education), electorates where more voters were paying off their homes were no more likely to swing towards the Coalition.

However, interest rates may have affected the result in a different way. At its core, Howard’s claim that rates would be lower under a Coalition government was a challenge to the ALP’s economic credibility. Having planned its campaign messages, Labor was forced to change tack midway, hastily rolling out advertisements to counter the interest rate ‘scare campaign’. After the election, the Australian Election Study found that voters tended to prefer the Coalition’s stance on taxation, unemployment, and industrial relations; and Labor’s policies on the environment, health and education.

The big challenge for the ALP will be convincing the electorate that it can run the economy almost as well as the Coalition. “Almost”, because the belief that right-wing parties are better economic managers is so pervasive in developed democracies that few can hope to topple it from opposition. Even on the eve of British Labour’s 1997 victory, a majority of UK voters thought that the Conservatives would do a better job of managing the economy than Labour. But because voters thought that Labour would be a lot better on social issues, the opposition won in a landslide.

The ALP’s economic credibility is now less likely to be hit – as it was in 2004 – by claims that interest rates will rise under Labor. Yesterday’s rate rise probably ensures that that the term “interest rates” is likely to join “WorkChoices” and “Iraq” on the Coalition’s list of unmentionables. Yet given that Labor devoted a considerable amount of energy in the last election to pointing out that governments do not control interest rates, it would be difficult for them to now turn around and blame high interest rates on the Coalition. Hopefully this double-edged sword will ensure that interest rates are not a first-order campaign issue, thus making room for more meaningful policy debates.

This would be good news indeed. Another “keeping rates low” election would not only be mind-numbingly boring – it would also represent a missed opportunity to discuss some of the real challenges that Australia faces as a nation. Forget interest rates: let’s talk about something the government can affect, like improving the performance of our schools and universities, how to decide on our infrastructure priorities, or getting the tax mix right.

Dr Andrew Leigh is an economist in the Research School of Social Sciences at the Australian National University.

(Incidentally, someone from the RBA called me this morning to say that the “unwritten rule” is a myth, and that it’s merely a coincidence that the Bank hasn’t previously raised rates in an election year.)

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7 Responses to The Political Economy of Interest Rates

  1. Rajat Sood says:

    Nice article, Andrew. One thing I’d say though is that there is a genuine debate starting now about IR, even if “Workchoices” is itself unmentionable. After all, the BCA (?) has commenced an ad campaign on the subject. To an extent, the debate on interest rates has been a phony proxy for a debate on IR. I’m hoping that that ‘real’ debate will begin in ernest now.

  2. Wow. Point 1: I found a pretty decent sized mortgage effect in regression analysis of seat-by-seat swingsin 2004, with controls for education (this was aggregate level stuff, see here. Point 2: Richard Gerlach is my colleague (and head of discipline) here at Sydney on this visit; I wasn’t aware he’d published on political stuff.

  3. Christopher says:

    someone from the RBA called me this morning to say that the “unwritten rule” is a myth

    And there I was, assuming that a colleague of yours had been providing insights…

    but both things could still be true.


  4. Verdurous says:

    Storm in a tea cup. Most people realise the government of the day has only very indirect influence on interest rates. Coalition doesn’t deserve a kick in the pants for interest rates rising but equally shouldn’t have boasted about interest rates last election.

    If we really want to be serious about mortgage stress we’d take investors out of the market by abolishing negative gearing which is an enormous free kick for the wealthy.

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  6. Graeme Bird says:

    We cannot figure out whether it was a good or bad move to raise interest rates by looking at consumer-price-inflation. What we need instead is to compile Gross Domestic REVENUE figures and the figures for PRODUCTIVE EXPENDITURE.

    Failing that.. last I heard business profits were pretty high and that implies that monetary policy was too loose when those profits were being made. Of course then we have the problem of timing.

    Here’s a pdf to show how the Reserve Bank ought to be compiling its figures:

    Click to access Johnsson2.pdf

  7. Andrew Leigh says:

    Simon, apologies for not citing you on this. I went looking for some of the chapters in Mortgage Nation (particularly yours and Ian McAllister’s), but none were available online. The problem of my writing to a tight deadline, I suppose. Murray Goot also wrote to say that I’d neglected to cite Goot & Watson’s analysis using the AES.

    I’m still curious to see what it is about the functional form of your regression that causes the mortgage coefficient to differ so much from Easton & Gerlach’s. At the very least, the fact that their study didn’t find an effect makes me think that the relationship may not be all that robust.

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