Pearls and Irritations

The reforms recommended by the Review of the Reserve Bank have been well received, but it is questionable whether they will ensure that the Bank’s performance improves and that it can avoid the mistakes of the recent past.

The independent review of the Reserve Bank was commissioned by the Treasurer last July, and its report was released last week. This was the first review of the RBA and its independent role in setting monetary policy since the present framework was put in place three decades ago.

All 51 of the Review’s recommendations have been accepted in principle by both the Government and the Opposition. The response from the commentariat has also been very favourable, so it looks like we are all set to proceed with the recommended reforms.

The Reserve Bank’s performance

The starting point for the Review, as expressed in its opening paragraph, is that:

“Australia’s economic performance has been strong in the 3 decades since flexible inflation targeting was introduced. Inflation and unemployment have been both lower and more stable than in the preceding decades. The monetary policy framework, and the RBA’s actions, have contributed significantly to these outcomes. In turn, this success has underpinned confidence in the monetary policy framework and the RBA as a trusted central bank with a dedicated, high-quality staff.”

Despite its glowing assessment of the RBA’s overall performance over the last three decades, the Review’s recommended changes relied heavily upon its assessment of the Bank’s monetary policy performance in recent years when the environment for policy making has been more challenging. To this end, the Review focussed on 3 episodes: the low inflation period between 2016 and 2019, the policy response to the Covid-19 pandemic, and the recent increase in inflation.

Low inflation between 2016 and 2019

The criticism of the Bank’s performance during the 2016 to 2019 period was that inflation was too low, averaging 1.6 per cent – well below the target of 2.5 per cent – and unemployment was too high. Interest rates could therefore have been lower, but the Bank did not adjust the cash rate for a record 30 consecutive meetings.

At the time the Governor justified the lack of action to lower interest rates because he was worried how vulnerabilities associated with high household indebtedness and housing prices could affect economic stability. The Review found that the Board should have been provided with more information regarding the risks and there was insufficient debate around the RBA’s strategy and a failure to consider alternative strategies.

But personally, I would put more emphasis on the Bank’s (and the Treasury’s) poor forecasting record during those years when they constantly over-estimated the increase in both consumer prices and wage growth. The problem was that both authorities were focused on wages as the main (only?) source of inflation, and they over-estimated the rate of unemployment consistent with wage and price stability (the NAIRU). In particular, they did not recognise the significance of institutional changes affecting the labour market, but then neither did most other economists at the time.

The Covid-19 pandemic

Overall, the Review found that the Reserve Bank “acted decisively and successfully at the onset of the pandemic to protect against more severe outcomes and support economic recovery.” The Review was, however, especially critical of the bond buying program and the Bank’s use of forward guidance.

Modelling done for the Review showed that “The economic benefits of the bond purchase program appear to have been small relative to the scale and potential cost of the program.” In addition, the much faster rise in interest rates than was contemplated means that the financial costs have proved to be much larger than expected.

The most famous forward guidance provided by the Governor was when he said as late as November 2021 that the next cash rate increase would likely come in 2024. As the Review said, many people viewed the decision to increase interest rates starting in May 2022 as a broken promise, and it probably has damaged the Bank’s credibility.

I would add, however, in defence of the RBA’s actions during the pandemic, that there was enormous uncertainty on the one hand, while their main policy instrument, interest rates were at rock bottom, and thus effectively useless when the economy needed more stimulation. In the circumstances, the RBA was bound to experiment, and guiding public expectations and increasing the money supply through bond buying had a considerable logic so long as the authors were likely to be right in their assumptions and predictions.

Overshooting the inflation target sine 2021

In early 2021 signs of growing inflationary pressures began to emerge in many advanced economies. The Review found that the RBA was slower to respond than some central banks, but once it did it acted decisively with “one of Australia’s fastest tightening phases of monetary policy in the inflation-targeting era.”

With the benefit of hindsight, the Review considers that “the RBA was overly focused on its view that evidence of wage growth would be needed to achieve sustainably higher inflation. In addition, the Review found that the RBA’s forecasting models contain little detail of the economy’s supply side, and “could not sufficiently capture inflation dynamics during this period given the unique nature of the shock.”

I agree with the Review that the RBA, as always, was heavily focused on wage growth as the source of inflation. I am not surprised, however, that having overestimated wage growth during the 2016-19 period, the RBA decided this time not to act until they had clear signs that wage growth was picking up.

The recommended changes

Given the overall positive assessment of the RBA’s past performance over the last thirty years, it is not surprising that the changes recommended by the Review are not major.

Most importantly the RBA will continue to target inflation and unemployment, requiring it “to strike a balance between controlling inflation and supporting employment in both the short run and the long run”.

Interestingly the Review considers that “Equal consideration should be given to price stability and full employment in making such judgements.” One wonders if that was always true in the past, but now to reinforce the point, the Review says that “The RBA should systematically set out its assessment of its full employment objective as reflected in a range of relevant labour market indicators.”

Notwithstanding its overall positive assessment of the monetary policy framework adopted over the last thirty years, the Review’s assessment of the RBA’s performance during each of the three most recent episodes described above did lead the Review to recommend some changes.

Importantly the Review found that “Currently, the Reserve Bank Board provides only limited challenge to the RBA executive’s view and its skillset is not matched to the complex and uncertain economic environment in which monetary policy will increasingly operate.”

Accordingly, the most significant change recommended by the Review is that in future the RBA Board should be responsible for the governance of the Bank, but that responsibility for monetary policy should pass to an independent Monetary Policy Board, comprised of people with greater economic expertise.

However, the Review also blamed the failings of the recent past at least partly on the Bank’s “hierarchical culture” which it says slows decision making and creates an aversion to risk taking. Thus, in addition, to making much greater use of external economic expertise, the Review also recommended much more debate within the Bank, canvassing alternative policy options, risk analysis and scenarios, with more information available to the members of the Monetary Policy Board, and ways of improving accountability and the Bank’s public communication.

How much change can we expect?

It is hardly surprising that the main recommendation of a Review by three eminent economists is that monetary policy should be dominated by economists and that economic analysis, and public accountability and communication should be extended. But what difference can we then expect in the Bank’s performance?

As I read the Review’s Report, the RBA’s biggest failings were a less than adequate understanding of the labour market and how that was affecting wages growth, and a failure to properly allow for the influence of supply constraints.

But in both cases, most other macroeconomists were equally at fault. For example, I don’t recall economists (other than Joe Isaac and me) querying the RBA and Treasury estimates of the NAIRU and its influence in years past, and I doubt whether many economists have practical knowledge of possible supply constraints compared to relevant business-people.

In addition, there is a question about the role of monetary policy when faced with supply constraints that the Review does not address. For example, right now the two biggest supply constraints are energy and housing, and increasing interest rates is a very slow and inefficient way to try to bring energy prices down, while the impact of higher interest rates on housing is to further limit the supply of new dwellings.

Finally, while we are all in favour of improved accountability, I wonder about the impact of announcing the voting numbers for and against decisions following meetings of the Board and Monetary Policy Board. As a general rule, it is not deemed helpful if the public became aware of the degree of dispute around Cabinet decisions, and I think the same would be true of policy decisions by the Monetary Policy Board for much the same reasons.

Conclusion

In an uncertain and constantly changing world, policy makers should always be reviewing their performance, and this review is therefore to be welcomed. However, I doubt that the institutional changes recommended will make much difference. More will depend upon the quality of the people charged with the responsibility for monetary policy in future.