RBA Tackles the Big Issues

Attention in financial markets is, as usual, on the timing of the next interest rate change. Meanwhile, the statement on the conduct of monetary policy has set out the big issues.

This is a comprehensive view of how monetary policy fits within the macroeconomic framework, setting out scope and governance. It has far more content than the original exchange of letters be- tween the Treasurer and the RBA governor, which focused on set- ting the numerical target. The whole of the board, rather than just the governor, endorses the statement.

Many of the recommendations of the recent RBA review have been incorporated. Some old verities have been confirmed, and some ambiguities resolved. Others remain.

The Reserve Bank's independence is affirmed. So has the importance of a strong balance sheet, a central consideration when the Treasurer, in consultation with the board, decides the annual dividend distribution.

Appointments to the board will be made, as now, by the government, drawing from a list drawn up by the Treasury, the Reserve Bank and an independent third party, based on candidates' skills providing some constraint against political appointees.

In the early days of inflation targeting, there were different approaches to the inflation/employment nexus. The pioneer of inflation targeting New Zealand went out of its way to de-emphasise any connection.

The original RBA target recognised that it was absurd to pretend that monetary policy had no influence on employment. Primacy was given to inflation control, but flexibility was achieved by specifying that the inflation target should be achieved "over the course of the cycle".

The precise wording has changed, but the flexibility pioneered by the RBA has been retained, as has the focus on the centre of the target, rather than the edges of the band.

Over time, the 2-3 per cent has unfortunately come to be seen as a rigid target band. Being outside this unrealistically narrow band was judged to be failure. The statement tries to shift the understanding back to the original idea.

The bank will have to be more specific in its commentary on the likely path of both inflation and unemployment. But the inflation objective is specific while the un- employment objective is not, with acknowledgment that "full employment is an unmeasurable and changeable concept.

Over time, greater transparency has been a powerful trend among all central banks (including the RBA). Some would say that this cacophony has confused as well as enlightened. Nevertheless, the statement implements the review's recommendations that each board member should make at least one speech or public engagement each year.

Voting numbers at the bank board will be reported, providing still more fodder for speculation.

One resolved ambiguity is the relationship between monetary and fiscal policy. Previously, the unwritten rule was separation: the RBA didn't comment on fiscal policy, and the Treasury influenced monetary policy only through the secretary's place on the RBA board. Most treasurers confined their comments to reaffirming the bank's independence.

But after the GFC and Covid, there is a wider acknowledgment, at least internationally, that the fiscal austerity after the GFC was a mistake, and the near-zero interest rates of the post-GFC decade (an effort to compensate for austerity) caused financial distortions whose effects are still being experienced.

Observing the Covid experience, few would doubt the power of fiscal policy to stimulate the economy-so effective that the extreme settings of monetary policy now seem excessive. Hence the statement envisages some coordination, via the secretary's presence on the RBA board.

Another ambiguity has been removed. The secretary sits on the board as an individual, not as a representative of the Treasurer.

One ambiguity which remains is the role of unconventional monetary policy (UMP)-quantitative easing, zero interest rates and explicit foreword guidance.

The Reserve Bank was reluctant to follow the global norm into vigorous UMP, with interest rates remaining clearly positive until 2019. QE and explicit forward guidance on were a response to Covid. Few would judge QE or forward guidance as successful, and zero interest rates made the inevitable subsequent normalisation painful.

The review was lukewarm about UMP and so too is the statement interest rates are the normal instrument of monetary policy. A bolder message would have said that we hoped never to use UMP again.

On forward guidance Mario Draghi got this right in 2012 when he promised to do "whatever it takes to save the euro resolute, clear and without any commitment to specific policy action.

The RBA has adopted aversion of this as the standard concluding words in its policy announcements: "The Bank remains resolute in its determination to return inflation to the target and will do what is necessary to achieve that outcome". Anything more is redundant.

Ambiguity remains on the bank's role in financial stability. APRA doesn't get a specific mention, nor does macroprudential policy. "The Bank's mandate to uphold financial stability does not guarantee solvency for financial institutions, and the Bank does not see its balance sheet as being available to support insolvent institutions." Where does this leave the implicit guarantee of banks?

Nor does it resolve the old problem of asset prices lean against booms or clean up after the crash?

Perhaps the five-yearly review will tackle these vexed issues.