One of the first orders of business for the new government after the 18 May election will be to agree to a joint Statement on the Conduct of Monetary Policy with the Reserve Bank Governor.
Regardless of who wins the election, the incoming government should avoid repeating Scott Morrison’s mistake as Treasurer in allowing the Reserve Bank to formulate the statement in a way that downgrades the inflation target.
The latest agreement adopted when Philip Lowe became Governor in September 2016 introduced a new formulation for both the inflation target and the financial stability mandate.
The previous Labor government’s 2010 agreement made financial stability explicitly subordinate to the price stability objective. By contrast, the 2016 agreement turned this relationship on its head, specifically allowing for ‘flexibility’ in meeting the inflation target to pursue other objectives, including financial stability.
This was a significant reinterpretation of the RBA’s mandate compared to previous agreements and has important implications for how monetary policy is conducted and for the broader economy.
It explains why the RBA has been undershooting the central tendency of its 2-3% target range for four years and will continue to do so. The RBA has explicitly traded-off its inflation target against apprehended financial stability risks.
The 2010 agreement would have made such a trade-off more difficult for the RBA to defend.
It is questionable whether the government understood the significance of what it agreed to 2016. Newspaper reports at the time referred to ‘minor tweaks’ and then Treasurer Morrison said ‘it is similar to previous statements.’
The RBA doesn’t see it that way. Deputy Governor Guy Debelle has said that ‘the articulation of the financial stability objective’ is ‘the most substantive change’ since the first statement in 1996. Financial stability didn’t even rate a mention in the agreements prior to 2010.
The RBA derives its financial stability mandate from the second reading speech to the Australian Prudential Regulation Authority Act 1998, which spelled out the post-Wallis Financial System Inquiry allocation of responsibilities among financial system regulators.
However, the relationship between price and financial stability has always been subject to interpretation.
The traditional interpretation was that keeping inflation low, stable and predictable was viewed as the best contribution monetary policy could make to promoting financial stability.
By contrast, Phil Lowe has long argued that monetary policy may need to trade-off the inflation target and financial stability.
The Reserve Bank has done this explicitly since he became Governor, concerned that further reductions in official interest rates may give rise to increased financial stability risks.
This explains why the RBA has sat on its hands for 30 months, even as inflation and inflation expectations have been allowed to fall below target.
Yet this approach itself carries financial stability risks. It gives the economy a much weaker starting point should a negative shock actually occur.
It lowers nominal wages growth and constrains the revenue-side of the government’s budget. Scott Morrison made his own job much more difficult in agreeing to it.
Moreover, the RBA has undermined the credibility of the inflation target. Some commentators have called for the target to be lowered in the belief that the RBA can no longer, or should not, hit it.
But this would only serve to validate a monetary policy mistake. It would also undermine the RBA’s accountability for meeting the inflation target agreed with the government.
Below-target inflation is a policy choice the RBA has made. It is only defensible because Scott Morrison agreed to make it so.
An incoming Labor government would be on strong ground in arguing for a return to the 2010 formulation of the Statement it agreed to when it was last in office. The RBA would then be forced to re-prioritise the inflation target.
The Treasurer should also require the Reserve Bank Governor to hold a press conference after each quarterly CPI release to explain the outcome and its relationship to the inflation target to underscore the Bank’s responsibility for inflation.
If Ian Macfarlane and Glenn Stevens could hit the inflation target, Phil Lowe has no excuse not to.
The next government should also follow the US Federal Reserve in conducting a review of monetary policy tools, communication and strategy.
The Fed’s review takes its inflation target as given, but will consider whether existing policy tools are adequate to achieve and maintain it and whether communication can be improved.
Professor Lars Svensson, an international authority on these issues, should be asked to conduct the review.
Such an independent review would almost certainly find that trading-off the inflation target against financial stability concerns incurs more costs than benefits.