11 October 2021

Wide-angle review of the RBA is needed

Economic management in the post-pandemic world will need to co-ordinate all the monetary, fiscal and prudential tools together, writes Paul Bloxham, Chief Economist, Australia, NZ & Global Commodities at HSBC.

A review of the Reserve Bank’s performance and mandate, which was recently advocated by the OECD, is looking increasingly likely. However, rather than looking at the RBA in isolation, it would be far more useful to conduct a broader review of the whole set of macroeconomic stability policy tools and institutions.

This would sit well within a broader reform agenda to support Australia’s economic prospects in the post-pandemic period. Australia faces no lack of challenges, including persistently weak productivity growth, its shifting relationship with China, state-federal fiscal relations and developing coherent climate change and energy policies.

For the macro-economy, a big challenge is that monetary policy is largely at its limits. The RBA’s previously powerful cash rate tool is already near-zero and is expected to be there for quite some time. Very loose monetary policy settings are starting to cause other problems, including a housing boom that now requires tighter prudential settings.

At the same time, growth is being primarily supported by fiscal policy – which has made sense during the pandemic. But it is also increasingly clear that more fiscal support will be needed to help the RBA achieve its inflation target.

With these challenges, a narrow review of the RBA would seem insufficient.

Besides, recent reviews of the US Federal Reserve, European Central Bank and Bank of Canada, have generally seen the mandates of these central banks adjusted to be more in line with Australia’s. In the US and Europe, the central banks have shifted to more flexible “average” inflation targeting approaches, with the intention of encouraging higher inflation expectations. Australia has had a flexible inflation targeting regime from its inception in the mid-1990s.

Calls for the RBA’s inflation target to be lowered are misplaced. Much of the academic literature suggests that a key lesson from the post-global financial crisis period is that, in a world of lower-for-longer interest rates, higher inflation targets would work better. That way, central banks would have more room to cut their policy rates before they reached zero. Australia’s inflation target is already higher than most, at 2-3 per cent, versus the 2 per cent global norm.

A review of the RBA would likely highlight the fact that the central bank has persistently undershot its inflation target in recent years, as has occurred in many other countries. In retrospect, it could be argued that through 2017 and 2018 the RBA was overly focused on managing the housing boom and took its eye off the inflation target. Keep in mind that financial stability had been explicitly added to the RBA’s mandate in 2010.

Perhaps the RBA should have cut its cash rate further at the time to support inflation. However, we do not know whether this might have driven a further rise in housing prices and credit, creating financial stability risks.

At the time, the RBA governor, Philip Lowe, was actively and increasingly “jawboning” the government for greater support for the economy from fiscal policy. Prudential tools, which are managed by the Australian Prudential Regulation Authority, were also employed to cool the housing market.

The fact that the optimal policy response almost certainly required a more co-ordinated set of fiscal, prudential and monetary policy adjustments suggests that the problem is not the RBA’s inflation mandate, but either the breadth of its expanded mandate or the limits of the tools it has to achieve it.

Recent moves by the RBA to embrace quantitative easing and support the active use, by APRA, of macro-prudential tools, suggest the central bank is now prioritising getting inflation back to target over other objectives.

The increased use of macro-prudential tools shows that some power for managing monetary and financial settings has already shifted from the RBA board to the Council of Financial Regulators, the co-ordinating body for the leading financial regulatory agencies.

Likewise, quantitative easing is most effective if the reduction in the cost of government borrowing, through the bond purchases, actually encourages government spending. This further elevates the importance of fiscal over monetary policy.

It would be helpful for fiscal policy, which is now the most powerful of the policy tools, given an already near-zero cash rate, to be more focused on managing the economic cycle.

Although Australia’s highly co-ordinated economic policy response to the pandemic is to be applauded, once the emergency is over it will be harder for policymakers not to allow political imperatives to override optimal economic policy.

We have argued for some time now that as monetary policy has reached its limits, Australia ought to bolster the power of its independent parliamentary budget office.

With the RBA’s policy levers largely at their limits, it would be less than ideal if the politically independent economic manager were once again left to jawbone for fiscal policy changes, rather than being able to act. In short, a useful review of monetary policy should take a more holistic view of macroeconomic stability.

This article first appeared in the Australian Financial Review on 11 October 2021