With both the government and the opposition nodding their support, an inquiry seems likely into the Reserve Bank’s conduct of monetary policy over the past decade or two. I was a member of the RBA board from 2011 to 2016, so I guess I will have to take my share of the blame for whatever shortcomings it might find.
But before we look at the criticisms of the RBA, it’s worth considering a few points about what has happened since I left.
Whatever might be alleged about the RBA’s caution in the decade to 2020, it has undoubtedly been very bold since then. At the end of last month it held almost $251 billion in Australian government bonds — a little under a third of their entire value, and eighteen times the value of those it held just before the coronavirus struck. In the first sixteen months of the pandemic, the RBA bought bonds equal to 70 per cent of the vast federal government deficit created by the pandemic. Among other actions, it also set the overnight cash rate at practically zero.
The Reserve Bank’s boldness was matched by that of the federal government. Even now, emerging from the pandemic, the federal budget deficit is the second-highest on record, exceeded only by last year’s. Before the pandemic Treasury expected the budget to be in surplus by now; on its latest projections, we will still be in deficit forty years hence.
But the revolutionary expansions, fiscal and monetary, are over now. Year by year the federal budget deficit will be reduced as a share of GDP. Year by year interest rates will go up. Tightening will be the backdrop of the economy and the political contest.
The tightening has already begun. The Reserve Bank has rightly given up on its attempt to hold the three-year bond rate steady. At its February meeting the board is likely to agree to phase out bond buying. When it comes, the next interest rate move will be up. This year’s projected budget deficit, meanwhile, is less than last year’s, and the figure is projected to fall each year over the next three financial years. By 2023–24, with spending cut by 1.4 per cent of GDP and taxes rising by a bit over 1 per cent of GDP, the deficit is projected to be half the share of GDP it is today.
But the vast household savings accumulated over the pandemic — savings we are now spending — mean we probably won’t feel the tightening for quite a while. Borrowing rates are so low compared with what we became used to before the pandemic that it will be a while before the contraction bites.
During the pandemic monetary and fiscal policy became far more closely connected. When both monetary policy and fiscal policy are tightened over a long period, there is a serious risk of miscalculation. The Reserve Bank needs to know what fiscal moves the government plans, and the government needs to know what the RBA plans.
If monetary and fiscal policy will be contractionary for some time, we need to think about other ways of lifting living standards. Increases in productivity — in output per hour of work — ultimately determine most of that rise, and on this measure Australia was already slowing, as were most wealthy economies. The big question is what we can do to speed it up.
But what of the years 2011–16, when I was a participant, like all other members of the board, in the RBA’s decisions on monetary policy? This was a period when the unemployment rate rose, and inflation — while mostly within the target band of 2 to 3 per cent — was generally closer to the bottom of the band than the top. An inquiry might well conclude that interest rates could have been lower without risk of serious inflation, and employment and GDP accordingly higher.
But critics sometimes overlook the fact that we were cutting interest rates throughout that period from 2011 to 2016, and quite vigorously. The cash rate was 4.75 per cent in June 2011. By July 2016 it was 1.75 per cent. That’s a pretty big cut. At 1.75 per cent, the cash rate in the middle of 2016 was lower than it had ever been.
Most of the time those rate cut decisions were sharply criticised. The Australian Financial Review was usually unhappy, arguing that tax and industrial relations changes were needed instead. The cuts generally went against the public advice of a “shadow” board of academics and others claiming expertise in monetary policy. The RBA cut a lot faster and deeper than most outside commentators expected, or preferred.
Nor were the cuts without effect. Mining investment was falling dramatically as projects were completed, and interest rate cuts in Australia couldn’t change the plans of global mining businesses. But what monetary policy could do, it did. The Australian dollar’s exchange value tumbled. Exports did well. Housing construction boomed. Household consumption growth remained firm. Overall, GDP growth averaged only a little under 3 per cent.
It is true there were no further rate cuts between August 2016 and May 2019, a nearly three-year period. But it is also true that the cash rate, by then 1.5 per cent, was the lowest on record. When output growth slowed into 2019 the RBA resumed cutting rates. By the end of 2019 the cash rate was just 0.75 per cent.
With perfect foresight the RBA might have cut a bit faster. But surely the main point is that in the circumstances of those years monetary policy could never be quite as effective as some of the bank’s critics — internal and external — believed.
An inquiry could be interesting. But it is hardly relevant to where we are now. What does deserve examining is what is happening to productivity. This is an issue about which we don’t know enough — not the RBA, not Treasury and not the Productivity Commission. A conference of local and international experts would be a good place to start. Productivity is the most important question for our future, not the pace of interest rate cuts before the pandemic. •