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Sunday, November 28, 2010

RBA evolves its approach to monetary policy

One of the more fascinating disclosures coming from the RBA's testimony to Parliament on Friday was the repeated assertions by Glenn Stevens that the central bank has got behind the interest rate curve--ie, had to play catch up--far more frequently than it has been able to pre-emptively anticipate inflation with rates. This was all, of course, rationalisation of the RBA's move in November, which followed a very low 0.5% third-quarter CPI number.

It nevertheless fits well with the thesis I regularly outlined here in September and October regarding the need for the RBA to be even more forward-looking in its monetary policy approach. In fact, I think that following the mistakes made by Stevens et al in 2006-07, which the Governor seems happy to now acknowledge, this RBA has changed the way it conducts policy.

With such a large investment and income shock looming--and, in the RBA's words on Friday, very little spare capacity--it will be much less focussed on contemporaneous data (like the Q3 CPI), and more willing to take risks with the conduct of policy by backing its medium term inflation forecasts. This has big consequences: it means that the RBA runs the risk of making mistakes, which is, by the way, okay, since it can always reverse its decisions. It also means that monetary policy will be much harder to predict day in, day out.

But it fits perfectly with my asymmetric reaction function thesis: ie, having observed the mistakes it made in the recent past, and the disturbing upward drift in both core and headline inflation, and even more worryingly, increases in all measures of future inflation expectations, the RBA would much rather CPI undershoot rather than overshoot the target.

This also explains the other very interesting anecdote coming from the testimony: the RBA's repeated references to changing interest rates when you are uncertain that this is the right thing to do. To the RBA's mind, this is because when you are certain, it is much too late.

Here are some of the quotes:

"As each month goes by, you are closer to those impacts coming through the economy. So you are in a period where you are waiting to see how certain things resolve one way or the other—but you know that you cannot wait forever

But, having been involved in this process one way or another for quite a long time, I cannot think of very many cases in history where we looked back and thought, ‘Yep, we tightened too soon.’ I can think of several times where we looked back and thought we should have tightened a bit earlier. I think that if we are doing it right the decisions will be finely balanced most of the time—that is where we should be—and we will probably move a little bit earlier than the moment when it is clear that you have to. That is if we are doing it well. There is some risk that you do things you do not need to do—I agree with that. We have to balance that risk, obviously, against the risk of getting behind the game. Historically, for many central banks, including us, that has tended to be the mistake that we made."

And more…

"The truth is we could have delayed a month until December and then have done it without maybe making a material difference to the course of the economy. It is very hard to say that it would. The problem is that any month you can say, ‘Let’s just wait a bit longer.’ You kept waiting and then eventually what typically tended to emerge when that was the case in the past was that you thought, ‘Now we have to get motoring and catch up.’ I think it is better really to move in a reasonably timely fashion to a point where you might be able to rest for a while. That is a better position to be in. As I said earlier, yes, we will be criticised for being triggerhappy."

And more…

"...having observed this or having taken part in it for a long time, I do not think I can recall too many occasions when with an early rise we looked back and thought we wished we had not done it. I can think of occasions when we wished we had moved more quickly or sooner, and I think there have probably been occasions when you can look back and wish you might have started coming down sooner. It is easy for the process to have a lot of inertia, ‘Let’s just get a bit surer before we do anything.’ The problem with doing that is that once you are sure, you are late, almost certainly."