Monday, March 16, 2009

The RBA got it right!

Tomorrow the RBA will release the minutes to the board meeting held two weeks ago. It was at this meeting the RBA decided to hold the official cash rate at 3.25%.

The decision to hold, breaks the pattern of recent months. Since September 2008 the decision at each board meeting has been to cut the official cash rate. In fact the cuts of recent months appear unprecedented in terms of steepness and depth (see graph).

I believe the RBA got it right!

I believe this for a number of reasons. One of the main reasons can be summarised in one word: timing. It is an aspect of monetary policy that is often forgotten.

The influence of the official cash rate on the economy is best described by a phrase coined by Milton Freidman “Long and variable lags”. Specifically, it takes time for inflation (and the economy in general) to respond to changes to the official cash rate. Research indicates that a whole year may elapse before the full effect of a change in the official cash rate may be felt.

This means, the recent cuts, all of which have occurred since September 2008, have yet to exert their full influence over the Australian economy. In fact, only six months has passed since the first cut was made.

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