Every three years we elect members of our local community to manage government on our behalf. These ‘politicians’ are effectively directors of a board—namely the parliament—overseeing the carriage of government. They in turn appoint professional executives that manage government on a day-to-day basis. In respect of the economy, these executives typically work at the Treasury or the RBA, which are responsible for executing fiscal and monetary policy, respectively. While the RBA has a higher level of statutory independence than the Treasury, democratically-elected politicians appoint the RBA’s Board and its Governor and Deputy Governor. Every few years they also formally confirm in writing what it can and cannot do.
This latter document is known as the ‘Statement’ and supplements the meaning of the RBA’s original 1959 legislation that brought it into existence. (Previously, Australia’s central bank, which was the Commonwealth Bank of Australia, had been engaged in conflicting commercial banking activities to the consternation of its private sector competitors, amongst others.) The Statement records, “the common understanding of the Governor, as Chairman of the Reserve Bank Board, and the Government on key aspects of Australia’s monetary policy framework.”
As an historical aside, the first Statement signed in 1996 mistakenly forgot to mention the Board in this paragraph, and was executed by the Governor in his own capacity. The preceding Governor, Bernie Fraser, has put on the record that he had a problem with this since it reinforced the Board's widely perceived governance deficiencies vis-à-vis its ability to serve as a true check on the executive.
The Statement goes on to say that its purpose is to “foster a better understanding, both in Australia and overseas, of the nature of the relationship between the Reserve Bank and the Government, the objectives of monetary policy, the mechanisms for ensuring transparency and accountability in the way policy is conducted, and the independence of the Reserve Bank.”
Yet it would appear that the Statement that exists today does not accurately reflect the current conduct of monetary policy. In recent times, the RBA looks to have resolved to make arguably the single biggest change to monetary policy since the ‘inflation targeting’ framework was formalised in 1996.
Under the current Statement, the RBA has one and only one medium-term goal: to keep consumer price inflation within a 2-3 per cent per annum band over the cycle. By doing so, it believes it can foster the best possible employment and growth conditions over the long-run, as the Governor noted in a speech this week. In the short- to medium-term, however, the RBA has comprehensively demonstrated that there is a direct conflict between reducing inflation and maximising employment. It cannot, therefore, pursue all objectives at the same time. This motivates its explicit ‘inflation target’.
The RBA has been extraordinarily successful in meeting its inflation target since the disclosure of one. It has also argued that the singularity of its focus on an inflation target imbues it with considerable external credibility with employers and employees, and overseas investors, which enables it to ‘anchor’ these participants’ long-term inflation expectations.
Following the cataclysm experienced during the GFC, the RBA has decided it wants to pursue a more ‘flexible’ inflation targeting regime that gives it latitude, on very, very rare occasions (say, every decade or so), to use interest rates to ‘lean-against’ asset price inflation that is being fuelled by unsustainable credit growth.
There is a credible case that wild swings in asset prices that are propelled by leverage threaten the stability of the broader financial system, as we saw in the US and UK. One of the RBA’s regulatory responsibilities is to safeguard the stability of the banking system alongside APRA. There a natural synergy, it would seem, between the application of APRA’s current (and future) ‘macro-prudential’ tools to ameliorate banking risks and the prospect of ‘open mouth’ and ‘open market’ operations carried out by the RBA.
Put more bluntly, there is a theoretical case for the RBA to tilt, at the margin, monetary policy to further enhance its financial stability aims. For the avoidance of doubt, the key asset prices the RBA is thinking of here are shares, commercial property, and residential real estate. And contrary to what you might think, the RBA has concluded that the most frequent system risk is typically posed by commercial as opposed to residential property. In a future state of nature, we could see the RBA lift rates more rapidly than what would otherwise be dictated by its inflation forecast to push back against, say, a sharemarket boom that was being driven by a leveraged-buyout craze.
It is important for the public to understand that there are, however, risks with all of this. The last time the RBA meaningfully adjusted monetary policy in response to asset prices it ended up in tears: it kept interest rates too low for too long after the 1987 stock market crash in spite of substantial inflation pressures. The RBA was then compelled to quickly hike rates to extraordinarily high levels a few years later, which gave us the 17 per cent cost of capital that led to the severe 1991 recession.
These changes are also controversial, and have been directly questioned by both Dr David Gruen at the Treasury, and Dr Guy Debelle, who is an Assistant Governor of the RBA, in recent speeches. The Governor of the RBA himself has repeatedly acknowledged that the question of the nexus between asset prices and monetary policy is contentious, unresolved, and subject to vigorous debate.
As it happens, I am sympathetic to what the RBA wants to achieve. This was not my original position, which more closely aligned with Gruen and Debelle. I think there are some benefits to the monetary authority adjusting the speed with which it approaches its ‘target’ cash rate, in concert with jawboning and moral suasion, to assist in modulating the animal spirits that tend to amplify cycles in asset prices.
It is, nevertheless, critical to recognise here that central bank officials are subject to precisely the same human shortcomings and biases that generate these problems in the first place. There are thus nontrivial risks that opening this door today could lead a future governor in decades hence to make poor decisions. Accordingly, my concerns are orientated around governance, transparency and process.
I don’t think it is appropriate for unelected officials to decide that they are going to vary the way monetary policy is conducted in this country. This is just autocratic mandate creep. As both Gruen and Debelle have argued, the wrong decisions could wreak havoc on the economy and irreversibly damage the RBA’s recently-won credibility.
The delicacy of this situation is compounded by the fact that the RBA has not historically had the best track-record when it comes to accountability and transparency. The Board was made up of non-economist political appointees who staff, former governors, and former Board members have all argued struggled with the intricacies of monetary policy. The public used to be provided with no immediate information following Board meetings regarding the RBA’s decisioning (this has now changed with the release of very detailed minutes)). To this day, voting intentions are not disclosed. Journalists were briefed in advance of these meetings on the executive’s recommendations, leading financial markets to price in the executive’s views before the Board--which is our one democratic check on the executive--had an opportunity to evaluate the recommendations.
Since his appointment the current Governor, Glenn Stevens, has made tremendous improvements to the RBA’s governance processes. And the more I come to learn about the RBA, the greater my conviction that he is an outstanding Governor surrounded by an exceptional team.
Today I would submit that we should not jeopardise this progress. Rather than seeking to expand the RBA’s monetary policy mandate in a subterranean fashion without the explicit endorsement of government, I would encourage the Governor to formulate and agree a new Statement with the Treasurer. Modest changes could be made to the existing Statement to provide the RBA with the flexibility it seeks. At the same time, any changes should be deliberately restrictive to minimise scope for a future executive to reinterpret them and undertake destructively discretionary departures from the RBA’s inflation targeting framework.
These thoughts were prompted by the release of yesterday of an important ‘research discussion paper’ (RDP) authored by Paul Bloxham, Christopher Kent, and Michael Robson, which finds in favour of a more flexible policy approach.
Interestingly, this study was anticipated in a research note published by one of the authors, Paul Bloxham, earlier in the week for HSBC. (Bloxham left the RBA a month or so ago after 12 years of service.) Bloxham’s statement represented perhaps the most direct and definitive acknowledgement by an (ex) RBA official that the Bank had evolved the way it conducts policy:
”The [RBA’s] chosen method of application of ‘flexible’ inflation targeting allows for the possibility that ‘medium-term’ risks associated with low-frequency events [viz., credit driven asset price booms] may be accounted for in the timing of movements of interest rates.”
The RDP examines three case studies—Spain, Sweden, and Hong Kong—in which a central bank has sought to tackle asset price swings. It also reflects on the 2002-03 episode in Australia that some media commentators have erroneously concluded was an example of an all-seeing and all-knowing RBA bursting a bubble with interest rates.
In this context, the RBA confirms what I have stated many times before here [emphasis added]: “During the period, monetary policy continued to be set on the basis of medium-term prospects for inflation and output and the Bank was not targeting housing prices or credit growth.”
The most the authors can say is that the asset price and credit atmospherics at the time ensured that there was no delay in 2002-03 to the monetary tightening that was “required on more general macroeconomic grounds.”
Their conclusion is that after several years of striking asset price and credit growth a fortuitous combination of ‘uncoordinated’ action by APRA, ASIC and the RBA helped facilitate a soft-landing.
The RDP is, however, disappointing on two counts. First, it recognises none of the governance issues I outline above. Second, it never references David Gruen or Guy Debelle’s dissenting voices in opposition to this approach. This is a bizarre oversight given that Debelle is one of the RBA’s most senior officers while Gruen is effectively second-in-command at the Treasury (there are some vague references to previous academic work that Gruen has done on the subject).
In closing, I believe there are grounds for giving the RBA greater latitude in the conduct of monetary policy to account for, and seek to mitigate, irregular (or ‘low frequency) events such as coincident credit and asset price booms. This is entirely consistent with the RBA’s independent ‘financial stability’ brief. Possibly the single biggest benefit of this change will be the mere fact that participants believe the RBA is capable of using its interest rate stick to deal with these risks. The threat could be in and of itself sufficient to stifle the exuberance the RBA is targeting.
But these changes have to be made with the active support of government. They must also be explicitly incorporated into the Statement that articulates the scope of monetary policy. And any modifications should limit the extent of this flexibility to minimise discretionary decision-making risks.
A final observation is this. Monetary policy is becoming increasingly complex. Both the public and the RBA need a Board that is equipped with the requisite skills to evaluate the executive’s recommendations. Lay businessmen with no financial markets or economics expertise do not fit the bill. Equally, I am unconvinced that a Board full of academic economists would be a great idea either.
Perhaps the best approach would be to appoint full-time Board members that are practical experts in economics and finance. Warwick McKibbin is a bit of a rare fish in this regard insofar as he is an academic who has engaged with the real world (establishing his own hedge fund). Market economists who have worked in banking all their lives would probably make sound candidates.
