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RBA must not repeat the mistakes of three decades ago

03 August 2022

As it looks to tackle rising inflation, the Reserve Bank must be wary of raising interest rates too far and too quickly in the precarious global supply environment, Warwick McKibbin writes.

The review of the Reserve Bank of Australia (RBA) announced by the Australian Treasurer is a welcome development. Unfortunately, the review is being undertaken when Australia faces difficult economic conditions.

It would have been better if Australia had already adopted the international model of periodically reviewing the central bank. In New Zealand, it is legislated that the Reserve Bank of New Zealand undertakes a review of its performance every five years, which is then sent to expert international reviewers for assessment.

This approach is a normal review process rather than a response to public outcry in the face of major policy shifts and significant global economic shocks. A regular review minimises the problems that may emerge from political popularism, damaging an important economic institution that has served Australia well for many decades. A better time for this review would have been in 2018, when the RBA hosted a major conference on ‘Central Bank Frameworks: Evolution or Revolution?’.

The terms of reference laid out by the Treasurer focus on the most relevant issues. Indeed it follows very closely the letter written by 12 leading Australian economists suggesting what should be in the review.

It adds an important addition: the interaction of monetary policy and prudential regulation. Much of the prudential regulatory aspects of the RBA were transferred into the new Australian Prudential Regulatory Agency (APRA) in July 1998 after APRA was created following a recommendation of the Wallis Enquiry into the Australian financial system. The critical question is whether this should be reversed, but the review does not explicitly cover this issue.

The terms of reference address a wide range of issues. However, the most important are: whether inflation targeting is the best way to achieve the goals of the Reserve bank Act (1959) and the Statement on the Conduct of Monetary policy; the performance of the RBA in meeting its objectives; the governance of the RBA; and what instruments can be used by the RBA in implementing its mandate.

The critical issue is whether the RBA in its current form is fit for purpose given the likely geopolitical and economic developments in the world economy over the coming decades. This question was the focus of my paper with Augustus Panton at the 2018 RBA conference. It is even more relevant today.

There is extensive literature going back many decades on why inflation targeting works well in the face of demand shocks. If demand is strong, unemployment falls, and inflation increases. An inflation-targeting central bank should raise interest rates to reduce excess demand, bringing employment and inflation down to sustainable levels.

A supply disruption caused by a climate shock, a pandemic, or significant geopolitical disruptions of production networks is more problematic. Increasing interest rates to reduce inflation in these cases will also increase unemployment, accentuating the adverse effects of the supply shock.

Thus inflation-targeting central banks needs to carefully analyse how much a rise in inflation is due to a change in demand or supply. An alternative approach for central bank mandates, such as targeting a measure of aggregate spending in the economy, is likely to be better at internalising the tradeoff between unemployment and inflation.

In a country such as Australia, where there are significant terms-of-trade shocks, nominal GDP is probably not the best target. However, some measure of nominal spending abstracting from fluctuations in the terms of trade (such as Gross National Expenditure) is worth assessing.

After all, central banks don’t target headline inflation. They adjust the inflation to remove volatile items such as food and energy. The same could be done for a measure of nominal spending. Research suggests it would work well, particularly for climate shocks (such as rising temperatures or extreme climate events such as floods and fires, etc.) which are expected to increase in intensity and frequency over the coming decades.

Central bankers have made careers out of the inflation-targeting framework over a decade during which demand shocks have dominated. If there is rigorous research in central banks that finds inflation targeting is the best regime for supply shocks, particularly from climate shocks and climate policies, it would be good to have it made public.

The fundamental monetary policy errors made in Australia in 1989 of excessively raising interest rates to target the current account deficit made sense under a fixed exchange rate regime, but had a perverse effect under a floating exchange rate by sucking in capital from overseas and further worsening the current account.

The world had changed from the previous historical experience. The result was a recession Australia didn’t have to have, which caused high economic and social costs. The RBA Board should have challenged this perverse policy at the time as it was challenged by staff inside the RBA.

It is essential to look forward and ask whether inflation targeting is the best framework for central banks in the future of climate disruption and when there has been a significant expansion of debt in economies that will require strong nominal economic growth to assist in debt sustainability.

How should the RBA respond to the current situation of surging inflation? Interest rates should be increased to deal with the substantial increase in demand being driven by ultra-loose monetary and fiscal policies which where appropriate in 2020 and but less appropriate over the past year.

A neutral real interest rate is probably around one per cent and with an inflation target of two to three per cent a neutral real rate is likely around three to four per cent. It makes sense to head towards this range of policy rates.

An inflation-targeting central bank needs to ‘see through’ the additional supply disturbances as being temporary and not raise interest rates even further to offset the effects of supply shocks on inflation. This extreme tightening will worsen the output losses.

The risk is that, as in 1989, the RBA will raise interest rates too far and too quickly to tackle inflation impulse only demand shocks need to be offset with monetary policy. An RBA targeting nominal domestic spending would also be raising interest rates (but starting from last year when nominal domestic demand surged) due to continued strong nominal domestic spending growth but would slow the interest rate increase as nominal domestic demand growth returned to the band of 4.5 to 5.5 per cent.

This is a reasonable rate of domestic demand growth given a target of potential real growth of 2.5 per cent and inflation of two to three per cent.

The RBA has contributed significantly to Australia’s economic prosperity since its inception. Australia has a great deal to gain from having an RBA review and ensuring that the RBA is in a position to confront the global challenges in the coming decades that we know of today, let alone the surprises that will no doubt occur.

This piece was first published by the Australian Financial Review.

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