RBA Review: Limits to the Power of Monetary Policy

The review of the Reserve Bank of Australia should be seen as a bureaucratic success worthy of ‘Yes Minister’, the biting political satire of the British civil service.

The panel has recommended retention of the two key elements of the existing inflation-targeting framework – a flexible 2-3 per cent-centred objective and RBA independence. It also proposes opening the decision-making process to a wider group of outsiders with specialised knowledge.

This is likely to make the RBA governor’s role more challenging — to weld this diversity of advice into policy appropriate for the realities of monetary policy. But it is workable, provided the RBA has a strong and smart governor.

A review was inevitable. The RBA was commonly perceived to have made policy mistakes, particularly post-COVID. In any case, most overseas central banks have regular reviews and many have an expert committee including a majority of outsiders.

But not too much should change. The old system had worked well for much of the past three decades, based on flexible inflation targeting (FIT) and central bank independence. The COVID period had been unusually challenging and the economy had come through pretty well, overall.

There were plenty of alternative suggestions, ranging from Modern Monetary Theory, return to controlling the exchange rate, prioritising full employment, a nominal-income target and raising the target rate of inflation. Leaving aside their merits, there was no consensus around any one of them. Why have unresolvable squabbles?

Thus the task was, to bastardise Lampedusa’s wisdom, “so that everything can stay the same, it has to appear that nearly everything has changed”. The review panel could not labour for a year and then make no recommendations for change.

Hence nearly 300 pages of a report and over 50 recommendations. Its success is apparent in the bipartisan support for implementing the recommendations. Job done. Let’s move on.

But the deeper lesson, not articulated in the review, is that monetary policy is not all-powerful in controlling inflation or economic activity.

What Will Change?

Upgrading governance is prominent – largely the usual motherhood. With two boards rather than one, a new COO position with deputy governor rank, an academic consultative committee as well as the inevitable Monetary Policy Committee, there will be more people and much more debate.

But the inflation framework remains largely unchanged. A higher inflation target has high-powered academic support overseas. Nevertheless, the 2-3 per cent remains unchanged. There is much talk of coordination with fiscal policy, but a formal process or body – which might well have been dominated by Treasury – doesn’t feature. RBA independence survived.

Unemployment is now a formal target but without a specific target figure. This mimics Canada, home to one of the panel members. Its absence, when the RBA framework was put in place three decades ago, was a reflection of academic consensus at the time – the Tinbergen Rule that if there was only one instrument (interest rates), there should be only one target.

The RBA didn’t share this ‘one instrument, one target’ view, nor the monetarist view that monetary policy affected only inflation, not real variables such as income or employment.

In fact it was the initial RBA target formulation which pioneered ‘flexible inflation targeting’ (FIT), acknowledging that monetary policy affects both income and employment. The specification of ‘2-3% on average over the course of the cycle’ reconciled the influence of monetary policy on activity in the short-term while accepting that monetary policy can’t do much about trend growth or employment in the longer run.

This FIT model became best-practice almost universally, even in inflation-targeting pioneer New Zealand.

The review has kept the notion of a flexible target while abandoning the specific connection with the cycle, thus opening the central bank to pressure to prioritise unemployment over the bank’s comparative advantage — price stability. This is a pity: it is more likely that 2-3 per cent will be seen as a narrow target, rather than a central aiming-point for policy.

Archer Aiming at Centre

To justify change and placate those who believe that the RBA performance was faulty, the panel has identified periods when it judges that policy mistakes were made. It finds no fault before 2016-19, when the panel believes interest rates should have been lower. This is a curious judgement, as this period saw a steady fall in unemployment and positive growth. Moreover, the policy interest rate was 1½ per cent — zero or even negative in inflation-adjusted terms.

This purported mistake will be put into a broader global context later. Here, it is enough to note that this judgment may, implicitly, reveal the panel’s underlying model or mindset. 2016-2019 was the period when the rate of inflation was most clearly below the target band. If unemployment had been a concern, they would have identified the 2015 period.

But the RBA never saw 2-3 per cent as a narrow band and, in fact, over the three decades of targeting, the actual rate was outside the band most of the time while achieving an overall average within the band. The RBA formulation specifically rejected the idea of an ‘electric fence’ defining the border between success and failure. Like an archer, the bank always aimed at the centre of the target, but did not expect to hit it continuously.

If the RBA is to be faulted on the basis of missing the target, it would have to be the persistent (if modest) nature of the undershooting – going back much earlier than 2016.

Too Much for Too Long

Fault was also found in the RBA’s response to COVID. This period was unique. When COVID arrived, there was unanimity among economists that without strong government action, a very serious recession would occur – with 15 per cent unemployment being the common no-policy-response prediction. So, as the bank has argued, the RBA ‘threw everything at it’.

Given the circumstances, it would have been impossible for the bank to do nothing. Fiscal policy implemented an astonishing budget deficit equal to 10 per cent of GDP. Could the RBA stand by, arguing that this was a supply shock and that monetary policy could do nothing more than remain vigilant against inflation? Surely not.

With the advantage of hindsight, the near-unanimous opinion now is that the RBA did too much for too long. Exactly what the bank should have refrained from doing depends on the critic. There is, however, unanimity on one point: the bank left stimulus on for too long. It is hard to disagree, but it might be noted that the RBNZ was quick off the mark, raising interest rates in August 2021, six months ahead of the RBA, and the outcome has not been perceptibly better.

Given the generally critical assessment of the RBA’s COVID response, we might have expected the panel to include admonitions not to repeat its unconventional monetary policies (UMP) which, it is worth recalling, the RBA had refrained from using pre-COVID. But no, these are still seen by the panel as part of the RBA’s tool-kit, available for future deployment in the right circumstances.

The clearest UMP mistake was forward guidance. Some form of forward guidance is an intrinsic part of any inflation-targeting framework. Over the past decade, central banks everywhere have gone further in giving insights into their future policy moves.

There is some logic in this – it strengthens policy by affirming inflation expectations. That said, market pressures persistently urge central banks everywhere to provide specific policy insights into the unknowable future.

The original Australian inflation targeting framework got the degree of forward guidance just right. This framework set out how the RBA would respond to any prospective departure from its specified inflation target. No predictions were made on specific policy settings.

Whatever It Takes

Mario Draghi’s hugely effective 2012 guidance provides a similar praiseworthy example: he undertook to do “whatever it takes” to sustain the euro. This contains all the right elements and nothing superfluous: it is clear on the objective, resolute as to purpose and imprecise on the exact actions to achieve this. This description fits the initial version of RBA FIT.

As for the other elements of UMP, surely a wise future RBA governor would take a far simpler lesson from the COVID experience: do not do any of these UMP actions ever again. Stick to setting interest rates within a well-articulated FIT framework and resist market pressures to commit to specific future policy actions.

Will This Work Better?

If the review has largely avoided initiatives which would have made the framework worse, will the new system be better?

Probably not, as the overseas variants of FIT that are the model for the review’s recommendations have not performed better than the RBA — and may in fact have been worse.

Looking back on the expert advice which academics and market practitioners offered over the last decade, most advocated lower interest rates and vigorous use of UMP, especially QE, which would have made the post-COVID normalisation still-more painful. Some commentators actually contemplated negative nominal interest rates. Many were still defending low interest rates when the 2021 inflation surge was well underway.

Nevertheless, the idea of bringing in a greater degree of specialised knowledge might have some benefits – especially if the newcomers are former practitioners from financial markets and banks.

Will more academics help? Past boards have always had an outside academic, so it’s not as if independent academic expertise was unrepresented. The bank’s annual conference has, since 1990, provided an opportunity for academics to interact with the bank.

We might note not only the diversity of academic opinion (grist for a rich and sustained conversation), but also how academic fashion has changed over time.

When the FIT framework was established in the early 1990s, monetarism was still a common belief: many thought that inflation was ‘always and everywhere a monetary phenomenon’; that monetary policy affected only nominal variables, not real; that only unexpected policy changes had any effect; that central banks would tolerate inflation unless disciplined by a rigid rule; that zero inflation was the proper definition of ‘price stability’; that if you had only one instrument, you should have only one objective; and that fiscal policy either had no effect on economic activity or was so slow-acting that active policy could not help the cycle.

This was the era of a doctrinal belief in ‘efficient markets’: the economy was largely self-regulating, and any interference in markets was anathema. None of these views is in vogue today. What further revisions are in store?

But a framework which encourages more discussion among a wider group may well be beneficial. Former financial-sector practitioners will bring real-world perspectives. The academics will in time learn something about real-world monetary policy. More RBA staff will feel involved in the policy process.

FIT in a Global Context

So much for the review and its recommendations. The FIT framework was endorsed, with the implication being that any deficiencies were largely a matter of imperfect operational application, which can be corrected by expanding the decision-making group.

However, with the FIT monetary framework adopted just about everywhere, economic performance during the post-GFC period has been mediocre. Moreover, inflation control was lost just about everywhere in 2021 and has yet to be regained. Was there an operational failing, an intrinsic problem with FIT or unavoidable force majeure? To judge this, we need to re-examine monetary policy in the whole post-GFC period.

The 2008 global financial crisis seriously damaged bank and household balance sheets in America and Europe and left a legacy of a feeble recovery, as balance sheets were repaired and borrowers licked their wounds. At the same time, the GFC had necessitated very large fiscal expenditure, expanding government debt to levels many thought were excessive. After 2010, fiscal policy set about redressing the perceived excessive official debt by shifting to budget austerity. This ensured that the recovery was weak.

Fed Chair Ben Bernanke, with the lessons of the Great Depression front of mind, boldly asserted that monetary policy had all the tools it needed to counter these headwinds. This took the US to zero nominal interest rates (significantly negative in inflation-adjusted terms) for nearly a decade, as each attempt by the Fed to return policy rates to normal was met by a melt-down protest in financial markets –notably in the 2013 “taper tantrum”, reprised in 2015 and 2018.

Thus, near-zero policy rates were maintained for a decade and the lender-of-last-resort policies which had been needed in 2008 morphed into massive ongoing QE, further expanded every time the market had a hiccup. This had little effect on economic activity, because QE just swapped one government liability for another. The business sector, facing weak demand, had no desire to borrow and invest, no matter how low the interest rate. Policy was, in the words of Bernanke’s predecessor in 1935, ‘pushing on a string’.

But this policy did get interest rates down, all along the yield curve. While there was little direct effect on economic activity, there was big impact on asset prices (houses and equities), with traders in the financial sector using the low borrowing costs to ‘pick up dimes in front of steamrollers’ — taking big risks for tiny speculative gains.

A Decade of Near-Zero 

After a decade of near-zero rates, balance sheets were distorted and dangerously vulnerable. The financial sector had expanded its risky portfolios and households had historically high debt.

This was encouraged by the consensus view that low interest rates were the ‘new normal’, confirming Bernanke’s 2005 analysis of a ‘global savings glut’. Further verification came from econometrics promoted by John Williams, head of the New York Fed and influential policy-maker. His conclusion — that the neutral long-term interest rate was zero — was absurd. The interest rate is a key price, reflecting the value of spending power today compared with spending power in the future.

The RBA had resisted this ‘race to the bottom’ of global interest rates as well as it could, restraining the downward slide of the local policy rate at 2 per cent until 2015, then 1½ per cent until 2019 and not copying the UMP which was widely adopted overseas. But lower rates are hard to resist in a financially integrated world: if the RBA had kept rates at normal levels, the exchange rate would have risen, undermining our international competitiveness.

This left the global economy ill-equipped to cope with the shock of COVID. Supply-side shocks are always tricky for monetary policy: how to keep unemployment from rising while watching supply shortages push up prices. The standard answer is to let the price increases associated with supply shortages pass though without policy response. Thus it was normal that central banks were tardy in raising rates when the first signs of inflation appeared in 2021. There was much talk of ‘temporary/transitional’ inflation; the asset-price boom retreated; and there was no sign of a wages/price spiral.

Then, when it became abundantly clear that a return to normal rates was needed, the actual rate was so far below normality that the necessary upward shift had to be large and rapid, devastating those whose balance sheets had adapted to the decade of negative real rates.

The lesson that might be taken from the three decades of global FIT is that the FIT framework does a good job at getting high inflation down and keeping it down in normal circumstances. It does less well, however, when the environment is intrinsically deflationary. For economic activity, it is ‘pushing on a string’. But for investors and speculators, it drives up asset prices. It can be argued that these asset price increases boost confidence and expenditure, but this channel is uncalibrated and dependent on the particular circumstances of the moment. It is not a reliable (or sensible) channel to implement monetary policy. Should monetary policy work by inducing a housing boom, then pricking it?

When the policy rate gets down to around zero in inflation-adjusted terms, it is time for the central bank to say that its interest-rate instrument is still working powerfully, but that still-larger doses of low-interest-rate medicine will harm the patient, rather than help. It should not go on mechanically lowering interest rates in the futile hope of stimulating inflation. If more stimulus is required, the task falls to fiscal policy.

So, what does the review have to say about fiscal policy? There were many words about the need for coordination to ensure that the two arms of policy are pushing in the same direction. There was, however, no discussion of the contractionary stance of fiscal austerity during the five years of feeble recovery after the GFC. Nor was there any discussion of the role of fiscal policy in the COVID period, where it provided the main boost to expenditures, which might have been unwound faster when this excess demand set off inflation in 2021.

The two episodes demonstrate the power of fiscal policy, with fiscal austerity unhelpfully dampening the lacklustre post-GFC recovery, and equally effectively over-stimulating demand in the post-COVID period. The long-time received wisdom that fiscal activism has no role in the cycle (fiscal should be confined to the automatic stabilisers) needs reassessment. Treasury policy-making performance was let off the hook here. But we shouldn’t be surprised: Treasury was orchestrating the review.

In Summary

There is an old joke where the punch-line is: “you should put more men on the job”. This is the central thrust of the review. Governance will be strengthened which always means more jobs. More people will be involved in the policy-making process and they will spend much more time discussing and cogitating. This is not necessarily a bad thing.

But monetary policy is usually a relatively straightforward task – at least if compared with the varied and imprecisely defined remit of the Treasury. The three decades of FIT demonstrate that most of the time the setting of monetary policy is clear and uncontroversial: the task is largely technical, with the objective and the responsibility clearly defined. Policy-making is insulated from the complexities and compromises of politics. 

When shocks arrive (GFC, COVID) the basic mistake is to expect too much of monetary policy. Monetary policy is not all-powerful to offset shocks, and it operates in an environment of what one central banker calls ‘radical uncertainty’: probabilities are unknowable and models are of little use.

Avoiding extreme policy settings (in either direction) is a useful starting point. Policies judged to be appropriate ex-ante may well turn out to be clearly wrong ex-post, but this may be the best that can be done.

The key element to good policy lies beyond the scope of the panel. It is to have a governor who is well-versed in the practical experience of monetary policy, with the ability to work with the government of the day while retaining decision-independence. Moreover, the governor should be smart and self-confident enough to distil sensible policy out of the cacophony of diverse opinion being offered. This policy should not be a compromised consensus embodying an amalgam of all views, but should be based on real-world experience and common sense.