The Reserve Bank of Australia left its official cash rate unchanged at 0.75 per cent on Tuesday, a decision that was widely expected by financial markets.
Yet the case for monetary policy to do more remains compelling. The RBA presides over an extended undershoot of its inflation target and an unemployment rate above its own estimates of the "full employment" rate.
The Reserve Bank continues to expect a "gradual" improvement in both these key indicators, but this gradualness is entirely of its own making.
The RBA believes quicker wages growth is needed to return to its inflation target. But wages growth won’t rise while inflation remains low and the labour market won’t tighten quickly or significantly without further support from monetary policy.
This monetary policy stalemate between the RBA’s backwards model of inflation and the expectations of price and wage setters leaves the Australian economy dangerously exposed to an emerging global downturn.
With ample headroom on inflation and significant spare capacity in the labour market, there are few risks in taking aggressive monetary policy action to get ahead of these global dangers.
The financial stability concerns that misled the RBA into undershooting its inflation target have largely abated.
The often-heard complaint that rate cuts only help asset prices ignores the fact that an increase in asset prices is a symptom of improved expectations for economic growth and inflation. It is a sign that monetary policy is working.
Fiscal policy constraints
With the 10-year bond yield at record lows, financial markets are saying the RBA is doing too little, not too much.
For its part, the Morrison government has copped flak for supposedly doing too little with fiscal and structural policy to support economic growth. But this ignores the political and institutional constraints under which any federal government operates.
Expecting the government to effectively manage aggregate demand with fiscal policy while subject to these constraints is unrealistic.
The whole point of having an independent, inflation-targeting central bank and a floating exchange rate is that demand management is no longer hostage to these constraints and the uncertainties and inefficiencies of the political process.
As a demand management tool, monetary policy dominates fiscal policy in timeliness and effectiveness, even when interest rates are low.
While we would all like to see the government do more to raise the economy’s growth potential, this is a task that is largely independent of the economic cycle.
It does not relieve the RBA board of its singular responsibility for managing aggregate demand and meeting its agreement with the government on inflation.
The tentative signs of improvement in the global economy noted in Tuesday's statement from the RBA are partly due to aggressive monetary policy action by the US Federal Reserve. US monetary policy has sought to be pre-emptive in response to a deteriorating outlook, perhaps more so than at any time since the mid-1990s.
Yet the collapse in US long-term interest rates and the renewed inversion of the US yield curve suggests that even the Fed will have to do more.
The US Federal Reserve system has gone through a considerable period of soul-searching over its failure to provide accommodative monetary conditions after the 2008 financial crisis.
US policymakers now recognise that they dramatically underestimated the amount of slack in the labour market and the ability of monetary policy to remove that slack without triggering too much inflation.
Following its public review of monetary policy strategy, the Federal Reserve is considering instituting a make-up rule, whereby an undershoot of the inflation target would be corrected by a subsequent overshoot to maintain a stable path for the long-term price level.
It is a step in the direction of nominal income targeting that avoids many of the pitfalls that have plagued monetary policy, including excessive reliance on unobservable variables such as the equilibrium unemployment rate and neutral real interest rate.
Ask any central bankers around the world about their experience with monetary policy since the financial crisis and many will now tell you they should have done more and done it sooner.
The RBA gives every sign of being a reluctant rate-cutter and this is reflected in market expectations. Ironically, this stance only increases the likelihood of future cuts in the official cash rate by keeping expected future interest rates higher than they would be if the RBA communicated a greater willingness to ease.
The central bank should signal its willingness to do whatever it takes to return inflation to the mid-point of its target range in short order. If it can credibly commit to such a stance, financial market expectations can do much of the heavy lifting in supporting the economic outlook.