The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Saturday, September 10, 2011

The time has come to reform the RBA's 1959 Act (expect to hear more about this)

Now here's a colleague who does know what he is talking about when it comes to the RBA. Dr Stephen Kirchner of UTS and the CIS is one of Australia's leading (published) experts on the conduct of monetary policy. He has authored a typically incisive op-ed in the AFR on the increasingly-contentious question of the RBA's governance structures, which is a must-read for anyone interested in the topic.

Like Dr Kirchner, I have for some time been thinking about calling for reform to the RBA's antediluvian Act (albeit for different reasons), which in no way resembles the way monetary policy is carried out today, and has been the subject of explicit attempts by the RBA to supersede it with a more relevant and representative policy agreement with Government. This is known as the Statement on the Conduct of Monetary Policy, and was first formulated and signed by both the RBA and Government in 1996. Before I come to Kirchner's excellent op-ed, it is worthwhile reiterating what I wrote about the RBA's evolution of its own policy mandate for Business Spectator back in December 2009:

"Along with the US Federal Reserve, the RBA is somewhat unusual amongst central banks insofar as it has a ‘multiple objective’ mandate. Rather than exclusively targeting ‘price stability’ (ie, low inflation) the Reserve Bank Act of 1959 gave it three exceedingly broad – and sometimes conflicting – aims:

- the stability of the currency (prices) of Australia;
- the maintenance of full employment in Australia; and
- the economic prosperity and welfare of the people of Australia.

These aspirations are so wide-ranging that the RBA could arguably embark on any number of radical endeavours in the name of seeking to, say, ‘maximise the welfare of the Australian people’ – whatever that means.

One example of this was the misguided attempt (inspired in part by Paul Keating) in the late 1980s to use high interest rates to crush a burgeoning current account deficit. Yet, by 1990 households faced 17 per cent mortgage rates and the ensuing recession we had to have.

While ‘price stability’ and the 2-3 per cent inflation target are the dominant objectives today, this was not always the case. It is an interesting piece of largely forgotten history that there was a vigorous debate within and outside of the RBA regarding the integrity of the second abovementioned objective: that is, full employment.

Given the historical trade-off between inflation and unemployment, the conflicting full employment ambition was seen by RBA insiders to undermine the Bank’s inflation-fighting bona-fides at a time (in the early 1990s) when the RBA was just finding its feet.

The former Secretary of the Treasury and Keating-appointed Governor of the RBA, Bernie Fraser, has revealed that he advocated a different perspective. Fraser thought that the full employment ambition provided an important constraint on those inflation zealots who might seek to raise rates in an unreasonably aggressive fashion in pursuit of cutting the CPI:

“The multiple objectives of the Reserve Bank Act help make the trade-offs [between inflation and unemployment] explicit in Australia, which is one reason why I have always championed our approach over the more fashionable, inflation only objective of many other central banks…I see the Bank’s multiple objectives as a counter to the (understandable) preoccupation of central banks with low inflation…

“I felt a bit lonely on many occasions – and I argued with them about what they [Bank insiders] themselves focused most on – on low inflation. Unless the Bank can carry the broader community, and that means having regard for employment…you’re going to lose support for low inflation with people…And I don’t think it is too far away before you see some more intensive questioning of inflation only in the European Central Bank.”

Nonetheless, the RBA’s inflation hawks ultimately prevailed. Today, the RBA makes it very clear that full employment is a secondary objective vis-à-vis the dominant aim of price stability:

“Since 1993, these [three] objectives have found practical expression in a target for consumer price inflation, of 2–3 per cent per annum…Controlling inflation preserves the value of money. In the long run, this is the principal way in which monetary policy can help to form a sound basis for long-term growth in the economy.”

As I noted in my recent summary of the RBA's evolution...the first formal endorsement of the RBA’s inflation target and its independence came in 1996 when the Governor and the newly elected Howard government executed the Statement of the Conduct of Monetary Policy. According to the RBA’s historian, Stephen Bell:

“The Statement, while reiterating the broad objectives of the Bank’s charter – including the dual goals [of price stability and full employment] added: ‘Price stability is a crucial precondition for sustained growth in economic activity and employment.’ This gave the inflation goal ‘top billing’, making other goals conditional on it. Interestingly, reference to the Bank’s statutory goals – including full employment – was removed from the front matter of the Bank’s Annual Reports from that point on.

Bell relays that while former RBA Governor Bernie Fraser was publicly supportive of the Statement, he had private reservations. To quote Fraser:

I wasn’t a fan of the Statement. It wasn’t something that I would have pursued, for two main reasons. One, it gave more prominence to inflation than I thought the Charter justified and was appropriate – that issue of balance [between employment and inflation] had been an ongoing theme in my term at the Bank. And the second thing was that the Statement was essentially an accord between the new Governor and the Treasurer; the Board wasn’t involved at all. I thought the Board was a significant part of the Bank’s policy process.”

Dr Kirchner proposes reforming the RBA's 1959 Act to establish a dedicated monetary policy committee that is distinct from its Board. This seems like a sensible suggestion. I would personally like to see the 1959 Act reformed for a different reason: it has already been practically surpassed by the 1996 Statement (and subsequent iterations of the same agreement). It is now beyond time that the legislation itself is modified to reflect the changes that have been agreed to by the RBA and Government. The problem arises--as we are seeing today--when critics of the RBA rely on the conflicted and confusing text (from a policy perspective) in the half-century-old Act to undermine the RBA's commitment to price stability.

As I demonstrated in my December 2009 article, this is not a new concern: the same conflicts presented themselves to the RBA in the early 1990s when it was trying to establish its inflation-fighting credentials, which is precisely why it went about developing the 1996 Statement in the first place.  The obvious complication with the Statement is that it has no legislative effect.

It is forgotten by contemporary journalists that the RBA was not regarded as an 'effective' central bank at the start of the 1990s, according to the historian Professor Stephen Bell. These same scribes also confuse the RBA's purportedly 'stellar performance' during the 1990s and early 2000s with policymaking skill. This had much more to do with luck, as the RBA itself is slowly coming to acknowledge (Glenn Stevens and Ric Battellino have described recent monetary policy decisions as the most complex they have encountered in their careers).

Following the 1991 recession, the RBA did not face an existential inflation challenge until 2006-07. This was arguably not an artefact of especially prescient monetary policy settings, but rather likely driven by three key factors:

(1) the Australian economy was running a very large 'output gap' for much of the 1990s and early 2000s (see David Gruen et al's 2002 RBA paper quantifying this fact), which meant that there was substantial spare capacity in the labour market after the 11% spike in unemployment in 1991. That is to say, Australia could grow quickly, and expand employment demand, without exhausting the supply of labour resources and triggering wage inflation;

(2) the global economy had the benefit of importing disinflation from China via the latter's cheap products. As the RBA recently observed, this dynamic has, for the first time in over a decade, started to reverse: China is now exporting inflation to the global economy as its own wages and prices rise;

(3) the agility and efficiency of the domestic economy was enhanced by the microeconomic reforms introduced by successive governments in the 1980s and 1990s with a particular focus on improving the flexibility of Australia's historically rigid labour market to mitigate the risk of wage-price spirals.

It is an empirical statement of fact, which the RBA accepts, that it has failed to successfully anticipate the gravity of the two major inflation challenges it has experienced in the last decade. (Have a read of this speech by Assistant Governor Phil Lowe where he benchmarks the RBA's inflation forecasts against actual outcomes and concedes that they do not know exactly why they have underestimated the strength of the inflationary pulse once the cycle becomes entrenched.)

The first case emerged in 2006-07 and saw core or underlying inflation rise to 4-5% pa in mid 2008, which is way above the 2.5% pa mid-point of the RBA's CPI target range. This was temporarily dealt with by the effects of the GFC.

We are witnessing the second (related) inflationary episode right now, wherein the RBA has once again been 'surprised' by--and failed to predict (as demonstrated by its official forecasts)--the surge in core inflation in the first half of 2011.

I note here that notwithstanding the efforts of some economists and commentators to dismiss the circa 3.6% pa core inflation realised in 2011 thus far, the RBA's officials have resisted this temptation and, in testimony to parliament, characterised the inflation as 'troubling', 'broad-based' and not deriving directly from the resources boom.

More specifically, Assistant Governor Lowe has stated,"I think the underlying inflation pressures in the economy are really coming from this combination of relatively weak productivity growth and around average wage growth. That means that unit cost growth since the mid-2000s has been quite high."

In his op-ed for the AFR, Dr Kirchner offers several valuable observations as to why we need to reform the RBA's monetary policy decision-making process. Excerpts are enclosed over the fold:

"If some members of the trade union movement are to be believed, the Reserve Bank Board is hostage to the ‘big end of town.’ They apparently want the Board stacked with those who will support an easier monetary policy stance.

Yet it is far from obvious that the external Board members are biased in favour of an overly restrictive policy. The business people on the Board could more plausibly be accused of erring on the side of keeping policy too easy.

Inflation outcomes are the only relevant test of the past stance of monetary policy. With inflation running at an above-target 3.6%, it is difficult to argue that monetary policy has been too tight over the last 12 to 18 months...

The Reserve Bank has all but conceded that the external Board members are conflicted in their role as monetary policy decision-makers by suppressing the contributions of individual Board members when it releases the minutes of its meetings.

The rationale for this secrecy is to prevent the external Board members from being subject to external pressure from sectional interests. This fundamental conflict has long been an obstacle to greater transparency and accountability in Australian monetary policy.

Before Glenn Stevens became governor, the Reserve Bank resisted attempts to open up the Board to greater scrutiny. In 2004, when News Limited sought access to the minutes of Board meetings under Freedom of Information legislation, the Bank went to considerable expense to block their release in the Administrative Appeals Tribunal.

In an affidavit before the AAT, former Board member Dick Warburton argued that releasing the minutes would expose external board members to ‘undue criticism and pressure from the sectorial groups they nominally represent.’

The FoI process was eventually brought to an end via the government’s secrecy trump card, the conclusive certificate.

Governor Stevens has since presided over a new era of openness at the Bank. However, there has been little change to the statutory arrangements for monetary policy governance since the 1959 Reserve Bank Act.

These arrangements were in turn little changed on those of the former Commonwealth Bank, which had their roots in the class warfare of the 1930s.

The fundamental problem with these arrangements is the failure to separate monetary policy decision-making from the overall governance of the Bank. These arrangements are an international anomaly and highlight the extent to which the Reserve Bank was left behind by the revolution in central bank governance that swept the world in the 1990s...

The Reserve Bank Board is also exceptional in giving a government representative in the form of the Treasury Secretary voting representation. Former Governor Ian Macfarlane said that ‘no one has ever understood whether the Treasury Secretary speaks for Treasury or the Treasurer and I still don’t know the answer to that … The only time the question has been put to the test it was clear that the Secretary was representing the views of the Treasury and not the Treasurer.’

The Bank defends the existing arrangements on the grounds that the external Board members and the Treasury Secretary lend valuable perspective. But the Bank already conducts extensive business and industry liaison and the Reserve Bank Act explicitly mandates cooperation with the Treasury Secretary, so their presence on the Board does not add anything to the decision-making process apart from the potential for commercial and political conflicts of interest.

The Reserve Bank Act should be reformed to separate monetary policy decision-making from the Board. This will allow for more independent and expert input into monetary policy decision-making and minimise the commercial, political and other conflicts that big business, the unions and the Treasury Secretary bring to the existing governance arrangements for monetary policy."