Why the RBA is wrong, wrong, wrong...
The latest Statement on Monetary Policy has confirmed the failure of the Reserve Bank of Australia to implement monetary policy settings that are consistent with its inflation target and objective of full employment.
It used to be the case that the RBA could never have a medium-term forecast for inflation other than 2.5 per cent – the middle of its target range. The thinking was that if the RBA had a forecast an inflation rate of say, 1.5 or 3.5 per cent, that was based on current policy settings, it would adjust interest rates to ensure inflation would not reach those levels, and instead would return to the middle of the target.
The middle of the target range is an important goal for policy because it means the risks to the forecast are symmetrical. A forecast of, say 2 per cent, means that a 0.5 percentage point error could see inflation fall to a troublesome 1.5 per cent as much as it could rise to a perfectly acceptable 2.5 per cent, while a forecast of 2.5 per cent that turns out to be wrong by 0.5 per cent would still mean the RBA meets its target.
And even if the 2.5 per cent forecast turns out to be wrong as economic events unfold in ways not fully anticipated, it would adjust policy again to keep the focus on the 2.5 per cent. The RBA did this well until the global crisis came along and changed the growth, wage, inflation dynamics.
Which is where the recent RBA policy settings have been so wrong. It has been well over a year since the last interest rate cut. Recent data and the RBA’s own forecasts show that it will not have inflation within its target range for a total of at least four years.
The forecasts simultaneously show that the unemployment rate will be at 5.25 per cent in 2019, which is a considerable distance from full employment. Those 750,000 unemployed Australians should be affronted by the unwillingness of the RBA to have policy settings that will inflate the economy and increase the chances of 100,000 or more of them getting a job in a stronger economy.
The steadfast unwillingness of the RBA to cut interest rates further is based, it appears, on a fear that such action would create financial instability. In isolation, there may be a shred of substance in this idea given that lower interest rates in isolation might lead to a further ratcheting up of household debt and asset prices.
Yet recent bank profit results show financial stress easing, not rising, with bad debt levels remaining at historical lows and households are on average well ahead in their mortgage repayments.
To the extent that a continuation of the housing boom might present a risk to financial stability, it is vital to note the other failure of the RBA, to embrace and advocate other policy action, rather than unnecessarily high interest rates, to reduce this risk. The RBAs initial reluctance to advocate and then its facile attempt to encourage the financial regulators implement tighter lending standards on banks is a further example of its “strictly ballroom” approach to managing the economy.
Instructing the banks to limit dwelling investor credit growth to 10 per cent and now complaining that 6 and 7 per cent growth is still too high would be laughable if it wasn’t so serious. It illustrates the RBA’s acute misunderstanding of how to use policy settings to achieve important objectives even if those policies are a little unconventional.
Telling the banks to limit housing investor credit growth to, say zero to 3 per cent, would certainly curtail housing demand, reduce financial instability risks and allow the RBA to cut interest rates to improve the cash flow of debtors. It would also encourage much needed business investment, especially in the non-mining sectors.
Housing would weaken but the rest of the economy could growth, invest and employ.
Lower interest rates might also trim some demand for the Australian dollar, which would be another way of providing a little extra stimulus to the economy and employment. Instead, the RBA statements include dozens of comments to the effect that a lower dollar would be helpful for the economy, or that a high dollar is a threat to growth, whilst it does absolutely nothing to influence the dollar’s value.
The thinking of the RBA is stale.
It appears the policy failure is due to its inability to acknowledge and keep up with the dramatic changes in the global and domestic economy that have structurally lowered both the inflation rate and the speed at which the wages can grow.
The proof of the RBAs old-fashioned thinking is evident in the actions of its counterparts in the wake of the global crisis.
Prior to the crisis, who would have imagined for example, negative interest rates would be part of a central bank’s policy armory? Of that quantitative easing would be implemented by the central banks overseeing the economies that make up close to two-thirds of global GDP?
It was not fathomable.
But with dynamic policy makers such as the US Federal Reserve’s Ben Bernanke and Janet Yellen, the European Central Bank’s Mario Draghi and Japan’s Prime Minister Shinzo Abe, have implemented what used to be called unconventional policies. These economies are now seeing above trend growth and sharply lower unemployment which almost certainly would not have happened if interest rates were higher and QE avoided.
In the last few years, had the RBA set monetary policy that was consistent with a medium term inflation forecast of 2.5 per cent, the official cash rate would be about 1.0 per cent, perhaps a touch lower. This, in concert with a tightening in mortgage lending rules to address the housing concern, would have seen the unemployment rate forecast drop to around 4.5 to 4.75 per cent and wages and corporate profits would be higher that they are today.
It is a pity that the RBA has not taken a more pro-growth stance with its policy settings or been more forceful in advocating tighter regulatory standards on part of bank lending for housing. A pity that is for some of the 710,000 people currently unemployed and the further 1.1 million who have a job but would like to work more hours but are constrained form getting those extra hours because the economy just isn’t growing fast enough.
So come on RBA, get your head out of the clouds and textbooks, embrace the middle of the 2 to 3 per cent inflation target that used to serve Australia so well and cut interest rates so that employment and inflation can rise the next time the forecasts are updated.
Stephen Koukoulas has a rare and specialised professional experience over more than 25 years as an economist in government, as Global Head of economic and market research, a Chief Economist for two major banks and as economic advisor to the Prime...