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Friday, July 29, 2011

Is the RBA breaking its own rules?

By strict definition, the RBA is not currently abiding by the monetary policy rules that it has agreed with Government. Since March 2011 it has forecast above-target core inflation over the ensuing 3 years. Based on the latest data, the RBA's forecasts, which have been repeatedly revised up, would appear to (once again) underestimate the gravity of the central bank's inflation problems.

In November last year, the Governor of the RBA testified to Parliament, as he is required to do bi-annually. He was repeatedly asked by the electorate’s representatives--and the RBA’s masters--whether there was a risk that the RBA would once again get “behind the inflation curve”, and permit underlying CPI to run ahead of the RBA’s implied 2.5% per annum target. Governor Stevens was also asked to explain why the RBA’s inflation targeting performance had deteriorated over the last decade or so (with core inflation averaging 3% per annum in the preceding 11 years). Crucially, he was questioned on whether the RBA would be able to rectify these failures when faced with similar challenges in the future.

I would like to remind Governor Stevens of his own words, which are recorded by Hansard. To his enduring credit, the Governor was honest in acknowledging the RBA’s policy errors, which risk undermining its long-term credibility and hence the stability of consumers' (not investors') inflation expectations. Indeed, he carefully articulated a decision-making framework that would help the Bank avoid repeating them.

It is useful to start by quoting Governor Stevens on the significance of the RBA’s published inflation forecasts:

An inflation-targeting central bank has to say at any point in time that, as best we can tell in anticipation, things are going to be consistent with our target, and if they start to move in a way that looks like it is not consistent then we should respond to that. We have been responding to that. We have a fair degree of confidence that, with the right policies, we will achieve a two-point-something performance on average into the future.

How can the Governor's words possibly be true today when, based on the latest Statement on Monetary Policy, the RBA is forecasting above-target (“three point something”) core inflation out to 2013? If the RBA is being objective, it will further upgrade its near-term core inflation forecasts to above three per cent in the next few weeks. And yet how has Australia’s central bank responded to these projections? Interest rates have not budged since November 2010 while worrying underlying inflation pressures, which were identified after the first quarter data were released, have proven to be worse than the RBA forecast.

One can only conclude that the RBA’s Board, which is the formal arbiter of policy, and its management team, who are reported to exercise tremendous influence over the Board, are confused about the RBA’s objective function, and, more specifically, the RBA’s oft-referenced “policy of least regret”.

This is a touchstone Stevens has returned to time and time again. That is, the central bank’s decisions should always result in the “policy of least regret”. Yet what does the "policy of least regret" refer to? Does it mean avoiding community discontent associated with unnecessarily high rates? Insuring against the risk that employment and economic growth are a little too low? Or allowing inflation to exceed the RBA’s target for an extended period of time?

In Glenn Stevens and Phil Lowe’s own words, and in the text of the more formal Statement on the Conduct of Monetary Policy that is regularly signed by both the Governor and the Treasurer, the RBA has a singular policy objective: to keep “consumer price inflation between 2 and 3 per cent, on average, over the cycle.”. That is, the RBA is an “inflation-targeting central bank”, as Glenn Stevens argued in the quote above. Or, in the words of the Statement:

Since the early 1990s, inflation targeting has formed the basis of Australia's monetary policy framework. Since 1996, this framework has been formalised in a Statement on the Conduct of Monetary Policy. The inflation targeting framework has served Australia well and is reaffirmed in the current statement...The Governor takes this opportunity to express his continuing commitment to the inflation objective, consistent with his duties under the Act. For its part the Government indicates that it endorses the inflation objective and emphasises the role that disciplined fiscal policy must play in achieving such an outcome.”

The RBA’s policy aim is emphatically not to maximize economic or employment growth, precisely because these two goals directly conflict with price stability in the short-run. In recognition of this problem, the RBA has gone to great lengths to explicitly subordinate the employment and growth objectives as derivative consequences that flow from the maintenance of price stability. This is explained in the Statement with the words, “Price stability is a crucial precondition for sustained growth in economic activity and employment.”

I want to conclude with the Governor’s testimony to Parliament in November last year. His key points were that the RBA had a habit of waiting too long to respond to price pressures. That they had fallen into the trap of deferring their decisions in anticipation of incrementally more information so as to be "sure" they had a price stability problem. Yet given the relatively long lags between changes to the RBA’s cash rate and the impact of such on prices, one could not afford to wait to remove all uncertainty. Because by the time you do, it is far too late. You would be running policy retrospectively.

I would remind the RBA’s Board, the Governor, and the RBA's executive team that, on the RBA’s own "analytical measures" (the headline numbers are much worse), so-called "core inflation" in Australia has been running at about 3.5 per cent for half a year (or about 40 per cent above the RBA's implied target).

Contrary to some claims, the price pressures are very widespread. The “weighted median” core measure has been expanding at this same rate. That means that half of all the consumer prices in the core CPI have, in fact, been growing at more than a 3.5% per annum pace, as my friend Ricardian Ambivalence has pointed out.

Based on the clear logic the Governor outlines below, the RBA looks to have allowed history to repeat itself. It has not acted pre-emptively in the setting of monetary policy, and has, as a direct result, failed to meet its price stability mandate. The risk is that over the long-run this eviscerates the credibility of the RBA's 2.5 per cent per annum inflation target. That the RBA effectively drops (or lifts) the target:

"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."

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 trigger happy."

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…