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Posts on this website are general "tips" and nothing more than that and should never be used to make an investment or trading decision. All information should be carefully cross-checked against official sources for accuracy. Sparty's posts nearly always relate to companies that he either holds, has held or intends to hold.

Main ForumRestrictive Monetary Policy and NAIRU

  • It is important that we understand the framework in which the RBA manages monetary policy. Understanding how interest rate decisions are made is important, not in terms of whether RBA decisions are right or wrong, but that decisions are made which affect your investment strategy.

    The most important determinant of monetary policy is the fear of inflation. The RBA attempts to predict inflation on the basis that if the economy is at full capacity, then any additional demand will result in too much cash chasing too few goods, hence inflation. I found that the most important determinant of excess demand is the concept of full employment.

    A concept that at first appeared strange to me is that the RBA has determined that full employment has been estimated to be around 4.7%. At first glance, I would have to say that 565,000 unemployed people is really is a big number, and which the RBA thinks is a great number. This full employment concept is enshrined in NAIRU http://en.wikipedia.org/wiki/NAIRU. NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.

    The Australian Bureau of statistics publish this number.

    I think it is informative on how our society is managed if the Government think 565,000 is reflective of full employment, and therefore is acceptable as a matter of public good.

    So lets be clear - if unemployment falls below 4.7%, the RBA will lift interest rates and the Government will be inclined to make fiscal policy less accommodative, so that unemployment will rise. Remember 2008, as the world fell into the GFC, Australia's unemployment rate fell to 4.1% and the RBA lifted the cash rate to 7.25%. The unemployment rate trumped the GFC, otherwise the RBA would not have lifted rates.

    Nairu implies that the 565,000 unemployed people are the entrenched unemployed who wouldn't take a job even if you offered one to them. The great side benefit of so many unemployed is that it helps with wage negotiation. Employers will be relieved that the RBA will create unemployment if the rate falls to low.

    The ABS (Australian Bureau of Statistics) also publishes "Aggregate number of hours worked." Based on a standard working week of 37.5 hours you can convert this number into an equivalent full time employment number. Part-timers who only work a few hours a week are not counted as unemployed.

    Aggregate hours worked paint a starkly different picture than the standard unemployment rate. It shows a society that is trending away from full time employment, to one that is more reliant on casual work. If the basis of monetary policy is based on a full employment definition that is deficient then the predicted interest rate rises in 2011 will have clear implications for your investment decisions.

    It also points more clearly to a binary outcome for our economy that will become so much more dependent on a buoyant China whilst we have a restrictive monetary policy. If China slows, watch the world beat a path away from our door. Not saying that it will, but that is the risk.

    The concept that our economy is running at full capacity with an unemployment rate of 4.7% is not a subject that is discussed in the mainstream media, but tends to be accepted as common wisdom. Hopefully the issue can receive more scrutiny in the future.

    Michael Cornips

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