Australia, mate, you’re doing interest rates all wrong

In America, the Federal Reserve oversees an economy doing really rather well. Inflation is low, growth is strong, the unemployment rate is a meagre 5% and the economy is adding jobs at the heady rate of over 200,000 a month.

So in December, the US Federal Reserve board raised the official interest rate.

Markets reacted harshly. The US S&P 500 fell by over 20% by mid-January, wiping many hundreds of billions of dollars off the value of stocks.

The performance of markets after the rate rise makes the next rise a rather tricky one. The Fed has indicated there would now be two rate rises this year, down from four, but expert commentators doubt those are coming, and are raising questions about the institution’s credibility.

Fights about shifts in monetary policy centre on the timing. The reason timing is so fraught an issue is that the size of a rate rise is predetermined. And that is a problem.

The December 2015 rate rise — the debut move from Federal Reserve Chair Janet Yellen — was the first move of any kind since 2008. And the first rate rise since 2006. That’s eight years between rate rises. Raising was a big, risky move — and I mean big.

After holding rates in the 0%-0.25% range, they lifted to 0.25%-0.50%. If you consider the midpoints, that’s a tripling — from 0.125%-0.375%.

It is a significant shift, and it raises an important question. Why do the US Federal Reserve and the Reserve Bank of Australia move official rates in minimum amounts of 0.25%?

A rate rise of 0.25 percentage points was appropriate for the US in May 2006, with the federal funds rate at 5% and the market seemingly in fine form. That same size rate rise is also being considered now. Why?

Not all rate rises are exactly 0.25%. The US Federal Reserve shows flexibility on the other side. As interest rates fell, some cuts were 0.25%, some .5%, some .75%. The last and final cut was of the range .75%-1.00%.

The Federal Reserve is, rightly, happy to make cuts of more than 0.25% when it suits. Why not less?

Markets are likely to embrace small-quantum changes. They deal with them all the time. Currencies and bond yields fluctuate to many decimal places.

The technology is not an issue. In 1716, the Bank of England was able to cut official rates from 4.5% to 4%. By now, our level of finesse has improved. The RBA can, these days, match the official rates precisely to the target rate, as this graph shows.

The idea rate rises should be the same size as rate cuts is highly dubious. Economies crash hard when they crash, as the following graph shows. Unemployment rises quickly but falls only slowly. Rapid rate rises could easily impede those fragile recoveries.

The merits of gentle rate rising are especially salient when rates are low, recoveries are still tentative and markets are hyper-alert to any move.

Every major nation is likely to enter a period of rate rises in the coming years. This will be a crucial time in the recovery from the global financial crisis. All those nations — including Australia — should consider starting that period by throwing out old assumptions about the basic size of a rate move.