The Reserve Bank and its discontents
Is monetary policy working?
Monetary policy has a hard task. The Australian economy has not fully recovered from the shock of the pandemic. Households that took on excess debt in the five years to 2019, when the Reserve Bank kept interest rates too low (and made a rash promise about keeping them low), are now grappling with the burden of mortgage stress as interest rates have risen.
Interest rates are now back to levels that were considered normal in past times, but the speed of adjustment, with 13 rises over 18 months, has come as a shock to heavily-indebted households. The Reserve Bank justifies the rapidity of that rise by the need to suppress inflation, which had resulted from excess fiscal stimulation during the pandemic and the RBA’s own tardiness in lifting rates.
The Reserve Bank’s toolkit
Critics of the RBA say it has overshot. Monetary policy is powerful but is slow to take effect: the RBA should be patient. The RBA is driving the already weak economy into an unnecessary recession, they assert. The RBA claims that is navigating “a narrow path to bust inflation without a recession”, as the ABC’s Tom Crowley puts it.
Those criticisms are about the pace at which the RBA has raised rates. A more basic criticism is about the effectiveness of monetary policy, particularly the way it is guided in Australia by a target in a single indicator – a two-to-three percent rise in the CPI over the preceding twelve months.
At 3.8 percent that indicator is still too high. The easy job according to the RBA was to bring it down from 7.8 percent: the hard but necessary job is to deal with that remaining 0.8 percent. (Some indicators suggest that the inflation is already below 3.0 percent.)
Critics of monetary policy have long pointed out that monetary policy is a “blunt instrument” to deal with inflation. The ABC’s Gareth Hutchens goes one step further in pointing out that monetary policy has become blunter: Is it the Reserve Bank's fault that some people might have to sell their homes?.
In the textbook model, monetary policy operates to regulate income, but in Australia’s case its effect is to redistribute wealth, particularly housing wealth, exacerbating the gap between those with and without high housing debt.
This has come about because of the interaction of monetary policy with an unfair tax system, which has created high housing price inflation. The RBA doesn’t have the power to reform our tax system, Hutchens reminds us.
In his post Chalmers is more in touch with the economy than the RBA John Quiggin makes the same point as the Treasurer, that the RBA has misread the economic signals and is unnecessarily smashing the economy. He makes the further point that the RBA should stop being obsessed about that last 0.8 percent. It should settle for a higher upper bound than 3 percent. Quiggin writes:
The Reserve Bank has expressed concern that, without a rapid return to 2-3 per cent inflation, expectations might form around current levels near 4 per cent. What is not mentioned is that a large proportion of the macroeconomics profession, arguably a majority, believes that a 4 per cent target would be optimal.
That higher target rate would give central banks more leeway when they come to reducing rates, without needing to go to the damaging low levels that we experienced before and during the pandemic.
One could add to Quiggin’s case for a higher band, say 4 percent, by considering the way prices move when there is an economic disruption – a pandemic that breaks supply lines and causes businesses to re-think about “make or buy” decisions, the election of a government that ensures employers do not underpay wages, or which places a price on carbon to account for economic externalities. Such changes will result in a reallocation of resources, and in pure theory should result in price rises and falls, but nominal prices don’t fall: they’re sticky. A period of inflation above normal levels gives an opportunity for real prices to adjust.
The ABC’s Ian Verrender makes an additional point, complementing Hutchens’ point about the effect on mortgage stress, in his post Why the Reserve Bank will be forced to cut rates before year's end. Our policy rate (the rate set by the RBA) is a little lower than the rates in some other “developed” countries, a point the RBA often makes in its defence. But the effect of our rate movements on people’s mortgage payments is more savage than in other countries, because while we have predominately variable rate mortgages, in most other countries mortgages are fixed rate, he points out with data illustrating the differences. In other countries, when policy rates rise, people with existing mortgages are unaffected.
The politics around the Reserve Bank
The government has a strong political incentive to ensure that the Reserve Bank is independent and that the public understands that it is independent. It would be convenient for the government, at present, if the public were to see it as part of the unloved finance sector, but that would be short-sighted: it should be remote from both the government and the commercial banks. That’s one reason why the government would like to see removal of the clause in the RBA’s enabling legislation that allows the government to overrule its decisions.
The other argument for removing this clause is to reassure the world financial community that our central bank is truly independent. Even though Australian governments have never used this power, its removal would confirm the RBA’s independence.
Former treasurers Paul Keating and Peter Costello would like to see the clause retained, as would former RBA governors Bernie Fraser and Ian MacFarlane (who might be expected to stand for the bank’s full independence). Gareth Hutchens pointed this out in an article posted in February. His article reminds us that in the 1930s the Commonwealth Bank (the predecessor to the Reserve Bank) exacerbated the pain of the Great Depression by refusing to help the Scullin Labor government implement its depression-busting public works program. The issue is more complex than a “remove or retain”, and is more about specifying the conditions in which it would be used.
It’s now apparent that Treasurer Chalmers has been engaged in good-faith negotiations with Coalition treasury spokesperson Angus Taylor about securing Parliamentary support for a suite of changes to the RBA legislation, as recommended in a major review completed last year. The most significant recommendations are about removing the clause mentioned above, and splitting the bank’s board into a monetary policy board and another to run the administrative functions of the Bank, such as control of the production of banknotes. They’re entirely different functions.
Taylor has a clear incentive to negotiate a deal. He hopes to be treasurer, and he wants the RBA to have sound enabling legislation. He has voiced his support for the reforms, and he does not relish the idea of being treasurer constrained by legislation in which the Greens have had a large hand. He also probably realizes that the chance of a Coalition government holding office in the foreseeable future with a compliant Senate is close to zero. He would like to get the legislation fixed now.
It’s fairly clear that Taylor has been rolled in the shadow cabinet, as Michelle Grattan points out in her Conversation article: Coalition torpedoes bipartisan deal on Reserve Bank monetary policy board. This is confirmed in an interview on the 730 Report, in which Taylor uneasily squirms out of Sarah Ferguson’s questions about his backdown.
Chalmers is understandably angry, and has sheeted the blame on Peter Dutton’s negativity and Taylor’s weakness, as the ABC’s Jake Evans reports.
If he is to get any reforms through Parliament Chalmers will have to get them past the Greens, and in a 15-minute interview on Radio National Adam Bandt presents the Greens’ demands. There is something of an ambit claim in his demands, but he’s fairly insistent not only that the government retain its power to override the RBA’s decision, but also that it should signal its readiness to use that power.
That would send a worrying message to financial markets, even to the extent perhaps of raising government bond rates, increasing the government’s interest bill and reducing its fiscal flexibility, and indirectly resulting in higher interest rates generally. Surely the Greens understand this.
Or are they involved in a clever political strategy? They know that, in the present environment of complaints about high interest rates the government obviously doesn’t want to be seen as failing to use its powers to lower interest rates. They seem to be out to put the government in a politically embarrassing position.
This seems to be once again one of those unholy alliances in which the Greens have sided with the Coalition in order to contribute to the political defeat of the Albanese government. For the Greens it’s an easier life to use their power to block the legislation of a far right government than to negotiate good public policy with a social-democratic government. Protesting is easier than taking responsibility.
As for the government’s failure, yet again, to negotiate a “bipartisan” deal, it is slow to learn that it is not dealing with a Hewson or a Turnbull who are concerned to shape legislation for the public interest – albeit a different interpretation of the public interest than Labor’s. The Liberal Party headed by Dutton has in mind a single path to power that involves destroying the credibility of the Albanese government. It doesn’t matter if the cost of that is social division or damage to the country’s economy.