One of the reasons Australian lending rates have remained consistently so much lower than they were in the 1980s and early 1990s is precisely because of the RBA’s ability to firmly establish its inflation-fighting bona fides.
It has taken me a while to work this out, but I was wrong in criticising the RBA for jacking up rates right through to the middle of the GFC in August 2008 (ie, if you include the de facto rate hikes effected via the banks, which the RBA could have neutralised via cash rate reductions).
My reasoning as to why I was wrong is as follows.
First, you need to understand that the RBA is an inflation-targeting central bank and has effectively dropped its second, legislated target of maximising employment growth. It did this formally with the consent of the government in 1996 via the ‘statement’ signed by the Governor and Treasurer Costello (I have posted at length on this in the past, including quotes from all the key actors in the 1980s and 1990s).
The statement formally prioritised price stability above the RBA's other legislated objectives, which it was worried undermined its ability to manage inflation expectations. More specifically, there is a well-documented conflict between inflation and unemployment, which makes reducing both at the same time practically very difficult.
The second ingredient to the logic is the recognition that price stability in Australia is only a relatively recent innovation. RBA officials themselves have admitted (as I have shown previously) that at the start of the 1990s the RBA was not a highly regarded central bank. One of the complications it faced was precisely its dual inflation-employment mandate, which it is unique amongst the big economies in sharing with the Fed. The former Governor, Ian MacFarlane, has put on the record that this created credibility questions with the international investors that influence long-term interest rates, and the cost of capital afforded to our banks.
All of this means that vigilantly protecting the credibility the RBA (unwittingly) won through the 1991 recession, and following the adoption of its inflation target in the mid 1990s, is of first order importance to it.
Now let's turn to 2007 and 2008. After a long period of stable inflation, the RBA discovered that it had a serious inflation problem on its hands. It was also consistently underestimating the size of this problem. Yes, there was a case that this was partly driven by commodity prices, the first and second order effects associated with which should have eventually flowed through the CPI data like a pig-through-a-python (ie, they were 'level' and not continuous 'growth' effects).
But we also know that there were much wider price pressures emerging in the economy, partly as a consequence of unemployment hitting a multi-decade low of just 4%. These influences conspired to push both core and headline inflation well above the RBA’s maximum acceptable target. Its policy credibility was, therefore, at stake.
I think that this tells us that given the choice between avoiding a deep recession accompanied with higher unemployment and bringing inflation back into its mandated target, the RBA will likely opt for the latter. Two other related points were the fact that we had a new Governor on the scene in the form of Glenn Stevens, who had yet to establish his own inflation-fighting credentials with the market. Put differently, we did not know whether he would behave in exactly the same way as his predecessor. And there was also the point that up until this time, the Australian economy had experienced the best part of almost 15 years of uninterrupted growth. A managed downturn would not be the end of the world.
A fourth factor at play here is my belief that the RBA has an ‘asymmetric value function’ vis-à-vis overshooting and undershooting its 2-3% inflation target (people have a similar value function in the pain and joy they attribute to losses and gains). In this regard, I suspect the RBA would much prefer to undershoot rather than overshoot, all other things being equal. This is because (a) the damage to its inflation-fighting credibility, and hence its ability to anchor long-term expectations, is much greater when it overshoots as opposed to undershoots, and (b) there is a lot of empirical evidence to suggest that the incidence of high inflation is much more likely than deflation (precisely because central banks fail to do their jobs), and that it is harder for a central bank to cut inflation than it is to increase it.
Taking all of the above into account, the RBA might have quite reasonably felt that (a) it would rather err on the side of higher rather than lower interest rates given the asymmetry of the impact of high as opposed to low inflation on its monetary policy framework, and (b) it was quite willing in 2008 to accept a modest recession in the name of wrenching expectations back into its desired target range.
My erroneous argument at the time was that it should have exercised the ‘option to wait’ and studied the outcome of the GFC given the risk that the GFC could have triggered a very serious downturn indeed. The mistake I made was to assume that the RBA was attributing equal emphasis on employment and growth outcomes.
This brings me to the Bank of England. One of the least frequently discussed consequences of the GFC is the mounting politicisation of monetary policy. Most of the RBA’s peers around the world had similar success over the last two decades keeping inflation at bay following the adverse experiences during the 1970s and 1980s. But there are legitimate questions as to whether this newly-won credibility will persist into the future.
The first concern is the extension of monetary policy into the fiscal policy domain, which Willem Buiter, amongst others, has highlighted. Glenn Stevens himself has also recently remarked on this.
The channel for this change has been via the process known as ‘quantitative easing’ whereby the central bank hits its lower interest rate bound (ie, cannot cut rates any further) and opts for creating new government liabilities in order to inject additional cash into the system. This is no different to the Treasury issuing government bonds and using the cash raised to try to stimulate the economy. The question here is how can the central bank credibly unwind this activity and shrink its balance-sheet in an environment where the government of the day has big debts? That is, will the central bank be forced to discard its price stabilty objective and inflate the government out of its obligations?
The second, and possibly more worrying development, has been evidence of the subordination of the inflation target. We have seen this problem most strikingly arise in the UK where the Bank of England has only met its 2% pa inflation target in nine of the last 50 months. The Economist has an excellent article on this subject.
The key issue here is that with the UK Treasury undertaking fiscal austerity measures it needs the Bank of England to support the economy via low interest rates. The problem is that inflation is running above the Bank of England’s target.
So what does it do? Ignore the inflationary pressures for the time being on the basis that they will subside anyway due to weak growth, or maintain its credibility and crush inflation while risking sending the UK economy into another recession?
This is really the crux of the central bank’s challenge: that there may be periods, such as in the early 1990s, when you have to sacrifice growth and employment in order to permanently reduce inflation expectations.
The problem is that I doubt whether central bankers really have the stomach for taking on the challenge. That means that in these economies--thankfully not Australia’s--higher inflation and higher interest rates may return as permanent pieces of the economic furniture.
