Governor Ian Macfarlane may be pleased that he is
retiring in September if it proves, as I believe it will, that today’s interest
rate increase (perhaps even the last two increases) were unnecessary and
compounded the economic slowdown that is already under way. The big difficulty now is that Australia has become a
dual economy, with very strong growth in Western Australia and, to a lesser
extent, in south-east Queensland, while the rest of Australia is pretty flat.

This makes it very difficult to run the bulk of economic policy by using
interest rates, a particularly blunt instrument. With the debt levels and debt
servicing exposures of the average household today, greater than they were in
the late 80s when official interest rates were three times as high, it’s a very
high risk game to try to fine-tune with even small interest rate increases.

Moreover, higher interest rates sustain upward pressure on the Australian dollar,
which makes it even more difficult to export at a time when our export
performance has been particularly disappointing, even though we have had the
best trading circumstances for 30 years. There is also a significant imbalance
between a stimulatory fiscal policy and a restraining monetary policy, which
further makes it difficult to manage with such a blunt instrument. The
resources boom is undoubtedly also coming to an end.

While inflation has increased a bit, it hasn’t increased
anywhere near as much as might have been expected given the rapid acceleration
in oil prices over the last few years. It is unlikely to lead to significantly
high inflationary expectations in a slowing economy. Oil prices also have a
deflationary effect on activity which interest rate increases can

Our economic risks are particularly accentuated by the
unsustainable situation in the US with a growing budget deficit, a current
account deficit approaching crisis proportions, a lame duck President and
forthcoming Congressional elections where the Republicans are on the nose.

While the US is helped by the fact that surplus countries have very little
option but to hold the bulk of their international reserves in US dollars, the
big risk is that the US reaches an economic management credibility limit, which
produces a substantial portfolio shift resulting in a substantially lower US
dollar and much greater volatility in financial markets.