The minutes of the 5 February Reserve Bank board meeting were missing a normal member: Treasury Secretary Ken Henry. Instead he sent along David Gruen, executive director of Treasury’s Macroeconomic Group. That makes him one of the Department’s pre-eminent big picture people on the economy.

In view of the importance of the meeting — the board made the most significant switch in monetary policy we have seen for some time — it’s intriguing that Dr Henry didn’t attend. Perhaps he thought that some of the private sector board members may have needed one of the department’s best minds on the broader economy to reinforce the RBA’s advice.

And the RBA has won support from investment bank Merrill Lynch which today lifted its official cash rate forecast to 7.5%, up 0.50%:

We expect the RBA to raise rates by 25bp at both the March and May Board meetings. Within our analytical framework for assessing monetary conditions, the business cycle and inflation, several factors point to the need for further monetary tightening.

We are increasingly of the view that monetary conditions are not sufficiently restrictive when adjusted for the terms of trade income shock. The level of real interest rates, which has been eroded by rising inflation and the Taylor rule also suggest policy settings are not overly restrictive.

Intensifying inflation pressures and risks within an increasingly capacity constrained economy. We have raised our forecast for underlying inflation to 3.8% by June 08 (3.5% previously) and 3.5% by December 08 (2.9% previously).

But for the third time in two weeks, the AMP’s chief economist and strategist, Dr Shane Oliver has taken a contrary vie. He wrote in a note this week:

2008 is likely to see economic growth remain reasonably strong in Australia thanks to strong investment and exports. News of another 65% increase in iron prices reminds us that the Australian economy is still benefiting from the China boom.

However, the risk of the RBA going too far on interest rates combining with the global downturn to result in a hard landing for the economy in 2009 are rising.

There are many differences between the Australian economy of today and that of the late 1980s, but the drip feed of ever higher interest rates with little apparent economic impact for a long time is eerily similar.

The relevance of the late 1980s/early 1990s episode is that it highlighted how hard it is to know where the “tipping point” for the economy with respect to interest rates is and that once passed it may be too late to quickly turn the economic ship around. The risk is that we may be in danger of repeating the same experience to some (hopefully lesser) degree.

Peter Fray

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