The first thing to acknowledge is that inflation targeting, used in Australia since 1993, has been highly successful. Prior to the pandemic, the country enjoyed its longest period of economic expansion and a key reason for this was the low level of volatility in the economy, partly due to successful monetary policy. Australia's earlier monetary policy regimes were less successful.
The main challenges have been in recent years: first, with inflation persistently below the RBA’s target from 2015 to 2020, and second, the recent inflation outbreak. These do not reflect failings of the inflation targeting regime itself but rather the unprecedented nature of recent shocks, alongside changes in the RBA’s approach to implementation or interpretation of its mandate.
We think the key questions for the reviewers ought to be: Could changes to the mandate, central bank governance, implementation and toolkit have delivered superior economic outcomes in recent years, and are the current institutional arrangements fit for purpose to deal with likely future challenges?
In terms of its mandate, keep in mind the RBA has one of the broadest of any central bank. As legislated in the 1959 RBA Act, it is three-pronged, specifying that policy is set with price stability, full employment and the ‘welfare’ of the Australian people in mind.
How should the RBA weight its different objectives? Is it Governor’s discretion or for the board to decide? Should the inflation target be the only objective, keeping in mind it is a flexible target leaving a lot of latitude. Honing the way the RBA weights the multiple prongs of its mandate could help.
These questions are particularly pertinent to the undershoot of the inflation target from 2015 to 2020. At the time, the RBA Governor avidly noted that the mandate was broader than inflation. Recall also that, in addition to the three-pronged legislated mandate, the government had added financial stability in 2010.
The central bank was reluctant to further pump-prime household debt and, with the cash rate heading towards zero, the RBA noted at the time that fiscal policy should have been more supportive. Looser fiscal policy and tighter prudential settings, rather than looser monetary policy between 2015 and 2020, may have been a better mix.
This shows that strong coordination between the policy arms is critical. In the Global Financial Crisis in 2008 and pandemic of 2020, monetary and fiscal policy were highly coordinated. However, during more stable periods the arms of policy have been less aligned.
The gradual bolstering of the role of the Council of Financial Regulators in recent years is a positive development. But a more formal mechanism for fiscal and monetary policy coordination ought to be considered, perhaps through a greater role and mandate for the parliamentary budget office.
In terms of the recent inflation outbreak, the RBA is not alone in failing to foresee it. However, given the inflation impulse arrived in other major countries in 2021, earlier than in Australia, it is worth asking why the RBA did not move earlier.
Would a board including more external economists, rather than business people, have swayed the forecasts made by the RBA Governor and his large staff? We cannot know for sure, but a few more economists on the board would be in line with international best practice.
As far as the RBA’s toolkit is concerned, there are questions about the recent use of ‘forward guidance’ and its three-year yield target. Yes, these tools were new, experimental and applied in the extreme circumstances of the pandemic. But did the strong commitment to forward guidance deliver more costs than benefits, given the upside inflation surprise? Perhaps one lesson is that when forward guidance is used in future, it ought to be clearly stated as being conditional on the state of the economy, rather than time-based.
Finally, some observers have pointed out that as the world is now facing more supply shocks, inflation targeting may no longer be fit for purpose, so perhaps a nominal income targeting approach would be superior. More research on this should be done.
But the problem is not that central banks are targeting inflation, but that supply shocks are hard to forecast. Let’s not forget that the 1970s, a period of multiple supply shocks and high inflation, was also a key trigger for the adoption of inflation targeting in the first place. A review is appropriate, and some adjustments may be deemed useful, but extreme care needs to be taken not to break what has been, over the longer term, a successful policy framework.
This article first appeared in The Australian Financial Review on Wednesday, 7 September, 2022.